Property Rights and Economic
Development∗
Timothy Besley
LSE and CIFAR
Houghton Street
London WC2A 2AE, UK
Maitreesh Ghatak
LSE
Houghton Street
London WC2A 2AE, UK
The Suntory Centre
Suntory and Toyota International Centres for
Economics and Related Disciplines
London School of Economics and Political Science
Houghton Street
London WC2A 2AE
EOPP/2009/6
∗
Tel: (020) 7955 6674
Chapter for Volume V of the Handbook of Development Economics edited by Dani Rodrik and
Mark Rosenzweig. We are grateful to Hannes Mueller for research assistance. We would also like to
thank Madhav Aney, Oriana Bandiera, Avinash Dixit, Erica Field, Dilip Mookherjee, Gerard Padro i
Miguel, Dani Rodrik, T. Paul Schultz, Ragnar Torvik, Chris Udry, and especially, Oliver Denk and
Rocco Macchiavello for helpful comments. The usual disclaimer applies. Besley is grateful to the
ESRC and CIFAR for financial support.
Abstract
This chapter develops a unified analytical framework, drawing on and extending the
existing literature on the subject, for studying the role of property rights in economic
development. It addresses two fundamental and related questions concerning the
relationship between property rights and economic activity. (i) What are the
mechanisms through which property rights affect economic activity? (ii) What are
the determinants of property rights? In answering these, it surveys some of the main
empirical and theoretical ideas from the extensive literature on the topic.
JEL Codes: K11, O17, P14.
Keywords: Property rights, Economic Development.
This series is published by the Economic Organisation and Public Policy Programme
(EOPP) located within the Suntory and Toyota International Centres for Economics
and Related Disciplines (STICERD) at the London School of Economics and Political
Science. This new series is an amalgamation of the Development Economics
Discussion Papers and the Political Economy and Public Policy Discussion Papers.
The programme was established in October 1998 as a successor to the Development
Economics Research Programme. The work of the programme is mainly in the fields
of development economics, public economics and political economy. It is directed by
Maitreesh Ghatak. Oriana Bandiera, Robin Burgess, and Andrea Prat serve as codirectors, and associated faculty consist of Timothy Besley, Jean-Paul Faguet, Henrik
Kleven, Valentino Larcinese, Gerard Padro i Miquel, Torsten Persson, Nicholas
Stern, and Daniel M. Sturm. Further details about the programme and its work can
be viewed on our web site at http://sticerd.lse.ac.uk/research/eopp.
Our Discussion Paper series is available to download at:
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For any other information relating to this series please contact Leila Alberici on:
Telephone:
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© The authors. All rights reserved. Short sections of text, not to exceed two
paragraphs, may be quoted without explicit permission provided that full credit,
including © notice, is given to the source.
Contents
1 Introduction
3
2 Resource Allocation and Property Rights
2.1 The Role of Property Rights in Limiting Expropriation
2.1.1 The Basic Model . . . . . . . . . . . . . . . . .
2.1.2 Guard labor . . . . . . . . . . . . . . . . . . . .
2.2 Insecure Property Rights as a Barrier to Trade . . . . .
2.2.1 Property Rights and Trade in Assets . . . . . .
2.2.2 Property Rights and Collateralizability of Assets
2.3 Optimal Assignment of Property Rights . . . . . . . .
2.3.1 Optimal Ownership of an Asset . . . . . . . . .
2.3.2 Role of Tenancy . . . . . . . . . . . . . . . . . .
2.3.3 Communal Property Rights . . . . . . . . . . .
2.4 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . .
3 Endogenous Property Rights
3.1 Expropriation . . . . . . . . . . . . . . . . . .
3.1.1 Framework . . . . . . . . . . . . . . .
3.1.2 Commitment . . . . . . . . . . . . . .
3.1.3 No Commitment . . . . . . . . . . . .
3.1.4 Reputation . . . . . . . . . . . . . . .
3.1.5 Exit . . . . . . . . . . . . . . . . . . .
3.1.6 Secrecy . . . . . . . . . . . . . . . . . .
3.1.7 Public Ownership? . . . . . . . . . . .
3.1.8 Voice . . . . . . . . . . . . . . . . . . .
3.1.9 Heterogeneous Producers . . . . . . . .
3.1.10 Taxation and Expropriation . . . . . .
3.1.11 Cross-Sectional Empirical Regularities
3.2 Improving State E¤ectiveness . . . . . . . . .
3.2.1 A Simple Benchmark . . . . . . . . . .
3.2.2 Extensions . . . . . . . . . . . . . . . .
3.2.3 Empirical Regularities . . . . . . . . .
4 Concluding Comments
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2
1
Introduction
The term property right refers to an owner’s right to use a good or asset
for consumption and/or income generation (referred to as “use rights”). It
can also include the right to transfer it to another party, in the form of
a sale, gift or bequest (referred to as “transer rights”). A property right
also typically conveys the right to contract with other parties by renting,
pledging, or mortgaging a good or asset, or by allowing other parties to use
it, for example, in an employment relationship.1
While the classical economists, from Smith to Marx, accorded a central
position to the role of property rights (or, “relations of production”) in the
process of economic development, it is only recently that mainstream economics has come around to this point of view. The core welfare results of
economics concerning the role of competitive markets assume that property
rights are well-de…ned and costlessly enforced. The literature on economic
growth has traditionally focussed on savings and capital accumulation in an
institution-free world with perfect property rights.
The new institutional approach to development economics (North, 1990)
has, however, put concerns about e¤ective property rights at the centre of
thinking about development, recognizing that this requires an explicit departure from a frictionless world. According to North (1990):
“Institutions are the rules of the game in a society, or more formally, are the humanly devised constraints that shape human
interaction. In consequence, they structure incentives in human
exchange, whether political, social, or economic.”
Seen from this perspective, property rights are an important element of
the institutional structure of an econonomy. However, property rights are not
exogenously given - they evolve over time, driven by economic and political
forces. Therefore, a study of propety rights also requires consideration of the
arrangements, both formal and informal, that ensure that property rights are
well-de…ned and enforced. Recent advances in political economy have given
greater prominence to the role of the state in codifying and protecting such
rights.2
1
2
See Barzel (1997) and Alchian and Demsetz (1972).
See, for example, Acemoglu (2003).
3
By property rights economists typically refer to private property rights
a key feature of which is being able legally to exclude others from using a
good or asset. This a¤ects resource allocation by shaping the incentives of
individuals to carry out productive activities involving the use of the good
or asset, undertake investments that maintain or enhance its value, and also,
to trade or lease the it for other uses.3
However, other forms of property rights, such as communal property
rights, are important in many societies.4 In the case of common property,
such as a lake or a forest, individuals have use rights but do not have the
right to exclude others from using it. There are also assets where the transfer rights of owners are circumscribed. For example, slavery is prohibited in
modern economies. In general, property rights (both use rights and transfer
rights) are always circumscribed – for example, the owner of a plot of land
is does not have the right to carry out illegal activities on it. The nature of
these restrictions depends on the political, legal, and enforcement system in
place at a particular time and place.
When unpacking these ideas, it quickly becomes clear that there are many
important facets of property rights which go to the heart of how economies
work and give incentives for individuals and …rms to make productive investments. The term e¤ective property rights refers to a number of economically
relevant concepts. First and foremost, it refers to the fact that ownership
structures (whether collective or individual) are well-de…ned. This has a …rst
order impact on the distribution of wealth and consumption. By the same
token, property rights a¤ect the pattern of production by in‡uencing who
has use rights to an asset and allowing separation of ownership from control.
Thus the depth and nature of rental markets depend on the development of
property rights. Such rights also a¤ect the inter-generational evolution of
the wealth distribution, by having an impact on whether assets can be transferred from parents to children. Rights may also a¤ect the development
of markets, particularly credit markets, to the extent assets can be pledged
3
One of the earliest advocates of private property rights was Aristotle who thought
that property would be be more likely to be looked after if someone owned it or pro…ted
from it than if it were treated as common (Robbins, 2000 p. 18).
4
Changes in technology or demand that lead to a rise in the value of the asset are
argued to be key drivers of emergence of private property rights (see North and Thomas,
1973).
4
against default.
An important conceptual issue concerns the relationship between contracts and property rights. Both specify a set of decision rights: rights to
take some actions or to proscribe others. In a world with perfect contracting,
a rental contract is e¤ectively equivalent to a change in ownership because
these rights can be speci…ed for every foreseeable contingency. This idea lies
at the heart of the celebrated Coase theorem (Coase, 1960): in a world with
complete information and no contracting costs, resource allocation will be
independent of the allocation of property rights.
In a world with costly contracting, owning and renting are not equivalent
since not all uses of a good or asset can be speci…ed for all eventualities up
front. A corollary of this is the idea that property rights convey residual
control rights to the owner (Hart, 1995). These rights represent a source
of freedom to those who hold them, allowing them to decide what he or she
would like to do with the object (subject to any legal or technical constraints).
This will also a¤ect the holder’s incentives to invest in enhancing the value
of the asset, as well as those of others who might also have contractual rights
to use the asset.
This chapter develops a uni…ed analytical framework, contributing to and
drawing on the existing literature on the subject, to address two fundamental
and related questions concerning the relationship between property rights
and economic development. (i) What are the mechanisms through which
property rights a¤ect economic activity? (ii) What are the determinants of
property rights? In each case, the aim of the chapter is to survey the main
ideas in the …eld rather than to provide an exhaustive review of the literature.
In terms of the …rst question, we emphasize four main aspects of how
property rights a¤ect economic activity.5 The …rst is expropriation risk –
insecure property rights imply that individuals may fail to realize the fruits
of their investment and e¤orts. Second, insecure property rights lead to
costs that individuals have to incur to defend their property which, from the
economic point of view, is unproductive. The third is failure to facilitate
gains from trade – a productive economy requires that assets are used by
those who can do so most productively and improvements in property rights
facilitate this. In other words, they enable an asset’s mobility as a factor of
production (e.g., via a rental market). The fourth is the use of property in
5
See de Soto (1989, p.158-163) for a detailed discussion.
5
supporting other transactions. Modern market economies rely on collateral
to support a variety of …nancial market transactions and improving property
rights may increase productivity by enhancing such possibilities. We will
explore these arguments and discuss some of the relevant empirical evidence.
As far as the second question goes, the contribution of the chapter is to
explore how systems of property rights are created and evolve over time. To
understand this requires an appreciation of the gainers and losers from such
rights and the institutions that shape the process by which rights are created
and destroyed. Here, we look at lessons from history as well as contemporary
experiences.6
This chapter is organized as follows. In section two, we take a microeconomic approach to studying how property rights a¤ect resource allocation
in theory. We use this approach as a basis for reviewing some of the empirical
evidence on how property rights a¤ect household behavior. We also review
some general equilibrium implications of property rights improvements. Section three then discusses endogenous property rights. We look in detail at
forces that shape expropriation risk. We also discuss investing resources to
improve state e¤ectiveness in improving property rights. Section four o¤ers
some concluding comments.
2
Resource Allocation and Property Rights
In this section, we examine in detail the key economic arguments about the
economic role of property rights and how they a¤ect productivity. In this
section, we unify, and extend the arguments for secure property rights studied
in Besley (1995). We classify the various channels through which property
rights a¤ect e¢ ciency of resource allocation under two broad categories: …rst,
limiting expropriation, and second, facilitating market transactions. The former includes two subcategories: enhancing investment incentives by limiting
expropriation risk, and reducing the need to divert private resources to protect property. The latter too includes two subcategories: facilitating trade in
assets and improving collateralizability of assets, thereby facilitating credit
transactions. We will discuss both individual behavioral responses as well as
general equilibrium implications. We will also discuss the insights from the
6
There is an overlap with the issues covered here and Baland, Moene and Robinson
(2008).
6
literature on the property rights approach to the theory of the …rm, which
suggests a theory of optimal allocation of property rights.
2.1
2.1.1
The Role of Property Rights in Limiting Expropriation
The Basic Model
We begin with a very simple set up which will allow us to illustrate a series
of arguments very transparently. We begin by looking at a single producer
economy. For the moment, we assume that there are no markets or any form
of exchange. To …x ideas, think of this as a farmer who is endowed with a
quantity of land.
We work with a very simple stochastic output model where the farmer
1. This
commits e¤ort (time) e 2 [0; 1] ofpwhich he has an endowment e p
yields output A with probability e and zero with probability 1
e. Expected output y is therefore:
p
(1)
y = A e:
In this single input setting, the farmer’s decision is to choose his optimal
level of e: Since there are no labor markets, this choice will be driven by his
own disutility cost of supplying labor.
We assume that the farmer’s utility function is linear in consumption (c)
and leisure (l):
u(c; l) = c + l:
(2)
This formulation rules out income e¤ects and risk aversion.
We assume that property rights are imperfect in the sense that there is an
exogenously given probability 2 [0; 1] of expropriation. This could apply to
the output that is produced, or the land which is needed to produce output.
These are equivalent, so long as labor is a sunk input prior to whether or not
there is going to be expropriation.7
p
Given this formulation, expected consumption is c = (1
)A e: At this
stage, we make no distinction between expropriation and taxation nor do we
consider the choice of . The implicit assumption, which we will make more
precise later, is that there is an actor in the economy with coercive power
which can be used to tax, con…scate or steal. In section 3, we discuss the
factors that determine the choice of :
7
In principle, this could even apply to labor, e.g., "forced" labor.
7
The producer selects e to maximize:
p
(1
)A e + e
subject to the constraint e
solution is:
e
(3)
e: The …rst-order condition for an interior
(1
)A
p
= 1:
2 e
(4)
The optimal choice of labor of the producer is therefore given by:
e =
(1
)A
2
2
:
(5)
Since we require that e 1; we assume throughout that A 2: Correspond2
ingly, (expected) gross output is y( ) = (1 2 )A ; and the producer’s net
i2
h
surplus (taking into account the cost of e) is given by ( ) = (1 2 )A + e:
Using this, we have the following observation:
Result 2.1
Labor supply, output and pro…ts are strictly decreasing in .
This is really only like a standard model in which taxes create a disincentive to commit e¤ort. In this risk neutral setting, it also does not
matter whether is a …xed or known proportion of output, as with a tax or
a probability of full expropriation of all output. This result underpins the
standard "security" argument in favour of property rights which allow lower
. The same logic would extend to other inputs such as fertilizer or land
improvements.
There are three key assumptions that drive this result. First, the input
is sunk before the farmer knows whether there is going to be expropriation
or not. Second, more e¢ cient instruments for transfer are not available.
Therefore as with any form of outcome-contingent transfer policy, there is a
standard disincentive e¤ect. A lump-sum tax or a "pro…t-tax" would bene…t
both the farmer and the coercive authority.8 Third, the resource-endowment
constraint (here, labor) is not binding.
To explore the importance of the latter, suppose that the resource
p constraint is binding, i.e. e = e. In this case, gross output is A e; and
8
The natural question is, given this deadweight loss why does this form of imperfection
in property rights exist. We will examine this question in detail when we endogenize :
8
p
the producer’s net surplus is (1
) A e: At this corner solution, marginal
changes in have only distributional implications: labor supply and gross
output are una¤ected:
If competitive labor markets exist, then resource constraints are unlikely
to be binding.9 To see this, suppose that e can be sold in the market with
w = 1. We would get the same outcome in terms of productive e¢ ciency
in the benchmark model irrespective of the speci…c form of preferences of
the producer, or his endowments, such as e: In particular, the outcome will
be the same whether or not the labor endowment constraint binds. If, for
e the producer would hire in labor from the labor market.10
example, e
The e¤ect of would, of course, stay the same: like a tax, it distorts labor
usage.
2.1.2
Guard labor
In the basic model, there is only one margin of choice: how much labor to
put into production. Suppose now that labor can also be used to reduce
the risk of expropriation. This potentially creates an additional margin of
distortion caused by imperfect property rights. Poor property rights not
only reduce incentives to supply productive labor, it also diverts resources
(here labor) from productive to unproductive uses. Improvements in the
protection of property rights can then free up labor and enable households
to make unconstrained decisions.
There are two cases to consider. First, where the asset that is subject to
insecure property rights is involved in the production or income-generation
process, as in our basic model. A good example of this is agricultural land.
Second, where the asset subject to insecure property rights is not directly involved in the production or income-generation process. Residential property
9
A necessary condition for the existence of labour markets is property rights in one’s
own labour, i.e., absence of slavery or other forms of coercive use of labour. In this chapter
we will focus on property rights in non-human assets, such as land.
10
This is just an application of the separation property of agricultural household models: with complete markets, individual preferences do not a¤ect production decisions (see
Singh, Squire, and Strauss (1986)). This is taking prices as exogenous. Otherwise, household preferences will a¤ect production decisions when prices are endogenous: in economies
where people value leisure a lot, wages will be high and this will clearly a¤ect production
decisions.
9
is a good example of this.
To explore this, we modify the model by having two types of labor. Let
e1 2 [0; 1] denote "productive" labor and e2 2 [0; 1] denote "guard" labor
that reduces the probability of expropriation. We use a simple technology
p
e2 ), where 2 [0; 1]
to describe the probability of expropriation: (1
and 2 [0; 1] . This captures very simply the idea that expropriation is lower
if e2 is higher with representing the e¤ectiveness of e¤orts put into guard
p
labor. Otherwise the model is the same as the basic model, with A e1
denoting expected output. Now the producer’s decision problem is:
max (1
e1 ;e2
(1
p
p
e2 )) A e1 + e
e1
(6)
e2 :
Solving the …rst order conditions for both e¤ort choices yields:
e1 =
2(1
4 (
)A
A)2
2
and e2 =
(1
4
(
)A2
A)2
2
:
(7)
Several interesting implications follow immediately from these two expressions:11
Result 2.2 If the insecure asset is involved in the production process, then
in the case where the resource constraint is not binding: (i) improved
property rights (lower ) increases productive labor; (ii) there exists
1 such that guard labor is increasing in so long as
and
decreasing otherwise; and (iii) economic e¢ ciency is increasing in improved property rights (lower ).
This result says that the link between productive labor and secure property
rights remains. However, the e¤ect of property rights security on guard
labor is ambiguous in sign.12
11
Since A 2; 2 [0; 1]; and 2 [0; 1] these solutions for e¤ortpare both interior.
@ e
For the proof of (i), observe that the sign of the derivative @ 1 depends on the sign
2 2
on A (2
) 4: Now (2
) is increasing in and the maximum value that it can
take is 1: Therefore, the maximum possible value of 2 A2 (2
) 4 is 2 A2 4 but
2
by assumption
4 ( A) > 0 for all ; A; and : For (ii) observe that the sign of the
p
@ e2
derivative @ depends on the sign on 4 + 2 2 A2 8 : Clearly, this is positive for low
values of and negative for high values of : The proof of (iii) follows directly by applying
the envelope theorem.
12
10
The intuition for this …nding is as follows. As productive and guard labor are complementary: more e¤ort to protect property rights will raise the
expected marginal returns from e¤orts to produce more output.13 Formally,
e1 is increasing in , and so compared to the basic model, introducing guard
labor increases productive labor. Given this, there are two e¤ects of increasing on e1 as can be seen from the …rst-order condition. The direct e¤ect is
negative for the same reasons as in the basic model. But there is an indirect
e¤ect operating via e2 in the presence of guard labor. However, this e¤ect is
always dominated by the direct e¤ect. For (ii) observe that an increase in
raises the expected marginal return from guard labor while lowering e1 . The
complementarity between e1 and e2 means that this tends to reduce the expected marginal return from guard labor: For small values of the …rst e¤ect
dominates and for larger values of ; the second e¤ect dominates. However,
as one would expect, economic e¢ ciency increases when property rights are
more secure following the logic of the previous section: namely, because it is
a …rst-order “tax”on output.
Consider now what happens when the resource (i.e., labor endowment)
(1 )2 A2 (4+ 2 2 A2 )
> e). Then the …rst-order conconstraint is binding (i.e.,
(4 2 2 A2 )2
ditions are:
(1
+
p
1
= 1+
e2 ) A p
2 e1
p
1
p A e1 = 1 +
2 e2
(8)
where is the Lagrangian multiplier associated with the binding resource
constraint (the shadow price of labor). Using these two conditions together with the binding labor-endowment constraint, we obtain the following
p
quadratic equation determining e2 :
2
e2 + (1
p
) e2
13
e = 0:
(9)
This follows from the assumptions that the asset that is subject to insecure property
rights is also one where productive labor is used to generate income and the resource
constraints are not binding.
11
Solving (and picking the larger root as the smaller root is negative) we obtain:
e1 = e
0
2
41
4
1
e2 = @
4
1
1
1
1
+
+
s
s
1
4
1
4
1
1
1
1
2
32
e
+ 5
2
12
2
e
+ A :
2
(10)
It is now straightforward to check that e2 is always increasing in and e1 is
always decreasing in . Also, now anything that raises e2 (e.g., an increase
in ) will directly reduce e1 via the binding labor-endowment constraint.
In this case, productive and guard labour are substitutes, and the intuition
that guard labor diverts resources away from productive uses applies quite
clearly.
We next consider the case where the insecure asset is not involved in the
production process. This could apply, for example, if residential property is
subject to insecure property rights. This might a¤ect labor supply decisions
even though the asset is not directly used for income generation. Suppose
the asset is worth h to the producer if property rights are not violated, and
is worth h otherwise. As before, let e1 and e2 be productive and guard
p
p
labor. In this case, A e1 is expected income and 1
(1
e2 ) is the
probability that property rights are not violated. Therefore, the producer’s
decision is now characterized by:
max (1
e1 ;e2
(1
p
e2 )) h + (1
p
p
e2 )h + A e1 + e
e1
e2 :
(11)
For this case, we have:
Result 2.3 If the insecure asset is not involved in the production process,
then in the case where the resource constraint is not binding, the productive and guard labor supply decisions are independent and accordingly,
e1 is una¤ected by .
If the labor endowment constraint is binding, as before, e1 and e2 are
substitutes and any reduction in guard labor will increase productive labor.
In this case, if goes up, then e2 goes up and therefore e1 has to go down.
12
Therefore, e1 is decreasing in : If e1 and e2 are substitutes in the disutility
of labor (e.g., the cost of labor being e1 + e2 + e1 e2 where > 0) then this
e¤ect is further reinforced.
Note however that a binding labor-endowment constraint is an issue only
when the labor market is imperfect or absent. Otherwise, the opportunity to
hire labor at a given wage rate should, in principle, make the cost function
linear and separable as is the case when the labor endowment constraint is
not binding. However, it may be that there are di¢ cult agency problems in
hiring guard labor, i.e. preventing the hired guards from appropriating the
asset which would need to be considered.
We have abstracted so far from income e¤ects by making the assumption
of linear preferences over consumption and leisure. If this is not the case, then
there is a further channel through which property rights can a¤ect resource
allocation. To see this, consider a slight modi…cation of the above model.
Suppose that the insecure asset is not involved in the production process.
However, in the utility function of the producer, consumption (e.g., food)
and the asset (e.g., consumption value of housing) are complements. The
producer then maximizes expected utility as follows:
p
p
p
p
e2 )) (A e1 ) h + (1
e2 ) (A e1 ) (h) +e e1 e2
max (1
(1
e1 ;e2
where
2 (0; 1); 2 (0; 1) and +
conditions are:
n
p
e2 )) h + (1
(1
(1
p A e12 h
2 e2
h
= 1:
(12)
< 1: In this case, the …rst-order
p
e2 )h
o
2
A (e1 ) 2
1
= 1 (13)
Substituting e2 from the second equation to the …rst, and then totally dif1
ferentiating with respect to it is straightforward to verify that @e
< 0 for
@
small values of : Thus worsening property rights protection reduces productive e¤ort. The intuition is as follows: the expected marginal return from
supplying productive labor falls when goes up as consumption is complementary with the asset that is subject to insecure property rights. Clearly, if
there is a competitive insurance market then the risk of losing the asset can
be insured away, and once again will not a¤ect e1 :
To summarize, there is a variety of ways that guard labor supplied in
response to insecure property rights can be modeled. Moreover, the theoretical predictions are somewhat sensitive to the case being considered. Thus
13
broad brush conclusions are probably not warranted even though there are a
number of reasonable cases where the intuitive idea, that less secure property
rights property rights encourages the use of guard labor, emerges from the
analysis.
There is a literature that deals with the general equilibrium e¤ects of
guard labour (or, more broadly, self-defense) in a model similar to the one
above, but with many producers. The key idea is that individual investments
in protection entail a negative externality on the other producers as predators
are de‡ected from the protected to the unprotected properties. This implies
that the decentralized equilibrium is generally ine¢ cient as it has too much
protection.14
2.2
Insecure Property Rights as a Barrier to Trade
The e¤ects that we have studied so far could be studied in the absence
of markets. One key role of property rights is to facilitate exchange and
allow producers/consumers to exploit gains from trade. In the following two
sections we examine the role of property rights in facilitating exchange in
land markets (rental, sales) and in credit markets respectively.
2.2.1
Property Rights and Trade in Assets
Economic e¢ ciency is enhanced by having assets managed by those who can
use them most productively. But this depends on being able to write e¢ cient
contracts to trade. In our basic model everyone has the same amount of land,
and also, everyone has the same skill level. As a result, so long as there is
a competitive labor market, there are no e¢ ciency gains from having a land
market. Now we relax this assumption and allow some agents to have more
land than they want to optimally cultivate themselves, and some agents to
have less. This creates potential gains from trade via a rental or sales market
in land. But a necessary (but not su¢ cient) condition for this to take place
is to have well de…ned property rights in land. Otherwise, land will not be
o¤ered for rental or sale driven by the fear that lenders could lose the land
with some probability, or equivalently, receive only a fraction of the market
returns to land due to imperfect property rights in land. This will create
an additional margin of distortion due to imperfect property rights. As a
consequence, potentially gainful trades will be lost.
14
See de Meza and Gould (1992), and Dixit (2004).
14
To model this in a simple way we assume there is a continuum of agents
divided into landed (a fraction of ) and landless (a fraction (1
)). Suppose
that time is in…nite and rental contracts involve an up-front payment from the
landless farmer to the landlord. However, there is a probability of losing
ownership of the land at the end of the rental contract which we assume to
be one period.
At the beginning of each period a farmer receives a productivity shock
<
1: Let the probability of low productivity =
2 f ; g with 0
be p: This is assumed to be distributed independently and identically across
individuals, as well as over
p time (for the same individual).
Given , output is A e: Therefore, for a given , a producer who owns
land chooses:
p
(14)
max A e + e e:
e
This yields, given perfect property rights (and ignoring corner solutions):
2
2
e = 2A and ( ) = 2A + e: From now on, we set e = 0:
For a landless individual or someone who leases out land, there is an
alternative activity which could be thought of as working for a wage, that
yields utility u 0: We assume that:
(15)
( ) > u;
i.e., that any landowner prefers to operate his land to taking the outside
opportunity. In this situation, there are clearly gains from trade.
Suppose both landed and landless farmers face the same distribution of
productivity shocks. Then there is a fraction p of which is low productivity
and landed and a fraction (1 p) (1
) which is high productivity and
landless. Assume that
(1
p) (1
) > p or 1 > + p:
(16)
This says that there are more high productivity and landless than there are
low productivity and landed. Given this, in a competitive market, land is
scarce and rents will accrue to land owners.
In a perfect rental market land trades at a price
r =
u:
All land is fully utilized and has high productivity.
15
(17)
Now let us consider the decision problem when there is a probability
that the tenant will not return the land. Now we contrast two strategies
for a low productivity landlord: renting out the land and bearing the risk of
losing his land or cultivating it himself. As productivity shocks are assumed
to be i.i.d. over time, and in any future period when the landowner is lucky
and draws he would prefer to cultivate the land himself as this way he
does not bear the risk of losing it. Following this argument, we can now
set up two value functions, one which we call V when in the current period
land is rented out, and one which we call W when in the current period the
landowner cultivates the land himself. Then,
=
+ (1
) [(1
W =
+ [(1
p)W + pV ] :
V
p)W + pV ] ;
(18)
Solving for W as a function of V yields
W =
+ pV
:
(1 p)
1
(19)
We can now plug W into V , and after some manipulation we obtain
V =
1
1
(1
p)
p)
(1
(20)
:
Observe that V is decreasing in ; as we would expect.
Consider the autarky option whereby a landowner always cultivates his
own land. Let V 0 and W 0 denote his lifetime expected payo¤ from autarky
when, respectively, he has a low and a high productivity shock in the current
period:
V0
W0
( ) + fpV 0 + (1
+ fpV 0 + (1
p)W 0 g
p)W 0 g :
(21)
Solving these, we get:
V0 =
( ) (1
(1
p)) + (1
1
p)
:
(22)
Comparing V and V 0 we can see that if is small then V > V 0 because
in the limit when = 0, V has to exceed V 0 as the land is always with a
16
high productivity producer and the owner gets the full surplus. Consider the
opposite case when is high. Now there is a trade-o¤: with autarky there
are periods when the land is used unproductively, and with tenancy, there is
a risk that the owner may lose the land. Take the extreme case where = 1:
Now it is easy to check that if ( ) > 1 1 + p then V 0 > V : A su¢ cient
()
condition for this is > 2 1 p , in which case the right hand side is negative and
so even if
( ) = 0 the condition would be satis…ed. Naturally, if V 0 > V
for = 1 by continuity and the fact that V is monotonically decreasing in ;
we have the following result:
Result 2.4 If > 2 1 p ; then there is a ^ 2 (0; 1) such that for
^ there
is no trade in assets and land is cultivated by low productivity farmers.
The insecure property rights now lead to no trade and a per capita output
( ) : In this case, a fall in constitutes a Pareto
loss equal to p
improvement because those who rent out their land are better o¤, while those
who rent in land are indi¤erent.
In the case
( ) = 0 the autarky option, in a period the producer receives a low productivity shock, is equivalent to keeping the land idle. This
is consistent with the fact that in the developing world assets are often kept
undeveloped or idle due to insecure property rights.15 Increasing the security of property rights can therefore reduce the extent to which assets are
underutilized.
2.2.2
Property Rights and Collateralizability of Assets
Above, we showed that property rights facilitate trade in assets and thereby
achieve e¢ cient allocation of resources. In the presence of agency costs,
e¤ective property rights can facilitate the use of assets to mitigate agency
costs, thereby facilitating trade. A prime example of this is in the credit
market; when agency or enforcement costs are important, lenders may not
be willing to lend an e¢ cient amount or, in some cases, lend at all. Property
15
For example, landlords in India often leave their land fallow rather than leasing them
out for fear of rights and control to tenants due the presence of tenancy laws that provide
security of tenure to tenants and regulate rents. This prevents the land-poor from accessing
land through tenancy and is viewed as an unintended negative consequence of the existing
tenancy laws. See Hanstad et al (2008).
17
rights improve the ability of borrowers to pledge their assets as collateral,
and thereby relax credit constraints.16
A recent in‡uential advocate of the importance of this link between property rights and economic e¢ ciency is Hernando de Soto (2000, 2001) who
calls this the problem of “dead capital”. For example, he argues that:
“What the poor lack is easy access to the property mechanisms
that could legally …x the economic potential of their assets so that
they could be used to produce, secure, or guarantee greater value
in the expanded market.”de Soto (2001).
He proposes the following metaphor:
“Just as a lake needs a hydroelectric plant to produce usable energy, assets need a formal property system to produce signi…cant
surplus value.”de Soto (2000), p. 48.
While de Soto is the modern incarnation of this view, it has an important
lineage. For example, in his perceptive study of West African trade, Bauer
(1954) also recognizes the importance of poorly developed property rights
and the impediment to trade that they create when he observes that:
“Both in Nigeria and in the Gold Coast family and tribal rights
in rural land are unsatisfactory for loans. This obstructs the ‡ow
and application of capital to certain uses of high return, which
retards the growth of income and hence accumulation.”(page 9).
p To explore these issues. we use the same basic model as above. Thus,
e remains the probability that output is A. We now assume explicitly that
e 2 [0; 1] is private information to the producer (borrower) and set e = 0 for
simplicity. In addition to committing e¤ort, we now allow the producer to
use capital to enhance productivity. For simplicity, capital x is a discrete
variable that takes
p on the values 0 and 1: When
p x = 1; output is A(1 + 4)
with probability
e and 0 with probability 1
e. Thus, expected output is
p
A(1 + 4) e: The cost of a unit of capital is ; which for now is exogenously
16
There is now a large literature that focuses on the implications of credit constraints
for the path of economic development. See, for example, Aghion and Bolton (1997) and
Banerjee and Newman (1993).
18
given. We abstract from any direct insecurity of property rights to focus on
how they work through the ability to pledge assets. Given this, and absent
any frictions, the producer’s decision problem is:
p
x:
(23)
max
A(1 + 4x) e e
e2(0;1);x2f0;1g
The optimal choice of e¤ort, e, is given by:
e=
A (1 + 4x)
2
2
:
(24)
In this model the capital good x and e¤ort are complements. The expected surplus at the optimal e¤ort level is
1 2
A (1 + 4x)2
4
x:
(25)
1
A (1 + 4)
> A2 and
< 1:
4
2
(26)
For concreteness sake, we assume
1
[A(1 + 4)]2
4
The …rst condition ensures that under the …rst-best (where e¤ort is observable), it is pro…table to use the capital good. The second assumption ensures
h
i2
an interior solution for e:17 We will therefore refer to e = A(1+4)
as the
2
…rst-best level of e¤ort.
If the producer owned the capital, or if there were no moral hazard, i.e. a
lender could specify a level of e¤ort as a condition of lending to the producer,
then e¤ort as above would be e¢ cient and x = 1 would be optimal. The
analysis is more interesting when we make two key assumptions: (i) e¤ort
is unobservable and hence cannot be speci…ed in lending contracts (moral
hazard) and (ii) the producer has insu¢ cient wealth to post as a bond in the
event that he defaults (limited-liability). To capture the latter, we suppose
that the producer has an illiquid asset whose value is w. We assume, however,
that the assets can be pledged as collateral against borrowing x from the
lender: Limited liability implies that he can pay only up to A(1 + 4) + w,
when output is high and w when output is low.
17
Note that together these assumptions imply < 1: Given that we have normalized
the cost of e¤ort to one, this is an assumption in the relative price of the input x relative
to e¤ort e.
19
If illiquid wealth were large enough, we would be back to …rst best case.
It is as if e¤ort could be speci…ed in the contract. By varying the level of
collateral demanded, the lender could make the stakes high enough for the
borrower so that he puts in the …rst best e¤ort level.
It is now clear why property right imperfections will enter the story. Even
if the producer has some illiquid wealth that could be pledged as collateral,
it is necessary that the legal environment be able to support its use as a
bond against not repaying the loan. This is particularly striking in the case
where the level of illiquid wealth that the producer owns is large enough to
alleviate the moral hazard problem entirely but is prevented from doing so
by insecurity of title to that wealth. The illiquid wealth in this case is “dead
capital” in de Soto’s sense.
As we shall see, an economy could then be
constrained (in terms of output and e¢ ciency) by the absence of secure title
rather than by absence of wealth.
For the purposes of our exposition here, we model this constraint on
contracting in a very simple way. Suppose that if a borrower has wealth w,
then its collateral value is (1
)w, i.e. only a fraction of that wealth can be
used as e¤ective collateral. This could be given a stochastic interpretation:
with probability 1
the lender will be able to foreclose on the asset that
was pledged as collateral if output is low and the borrower is unable to repay
his loan from the output/revenue of his project.18 In concrete terms, the
parameter re‡ects that in many countries registering assets as property is
time consuming and costly.
To understand how property rights matter, we now solve for the optimal
debt contract as a function of : We will then be explore how changing
a¤ects optimal debt contracts. A debt contract is an interested payment on
a successful project, denoted by r, and a level of collateral, denoted by c, to
be paid if the project is unsuccessful. The expected payo¤ of the producer
with a contract (r; c) is:
p
p
e fA(1 + 4) rg
1
e c e
(27)
while that of a lender is:
p
er + 1
p
e c
:
(28)
The producer always has the option of not borrowing x. This creates an
outside option equal to 41 A2 : Assumption (26) guarantees that (in principle)
18
In Besley and Ghatak (2008), we provide a more thorough micro-foundation to this
story using a costly state veri…cation model.
20
there are gains from trade as long as e¤ort can be speci…ed in the contract.
A loan transaction takes place so long as the producer’s expected payo¤ is
above her outside option and the lender makes non-negative expected pro…ts.
Otherwise, the producer is credit-constrained.
Given r and c the producer chooses her e¤ort to maximize her expected
payo¤, which yields the …rst-order condition:
1
p fA(1 + 4)
2 e
(r
(29)
c)g = 1:
Solving this yields an optimal e¤ort level:
A(1 + 4) (r
e=
2
c)
2
(30)
:
This is the incentive compatibility constraint of the borrower. Observe that
e and r are negatively related, while e and c are positively related. This is
intuitive as r is a tax on success, while c is a penalty for failure.
In addition , the contract also has to satisfy the limited liability constraint:
(1
)w
(31)
c:
This says that the payment demanded from the producer when the project
is unsuccessful cannot exceed her pledgeable wealth.
Inspecting (30), it may appear as if it is possible to achieve the …rst-best
e¤ort level by setting r = c: However, since c cannot exceed (1
) w this
might not be enough for the lender to recover the opportunity cost of capital
( ). If that is the case, then the lender will need to set r > > c: This
will imply that e¤ort will fall below the e¢ cient level. This illustrates how
agency costs have bite in this world.
We now sketch how the lender will …x the optimal contract when the
incentive compatibility and limited liability constraints are binding. Substituting (30) and (31) into the lender’s payo¤ function yields the following
single variable decision problem to determine the optimal interest payment:
max
r
A(1 + 4)
(r
2
w(1
))
(r
w(1
)) + w(1
)
:
(32)
Solving this yields:
r=
A(1 + 4)
+ w(1
2
21
):
(33)
In this case, the lender takes one half the return from a successful project
in addition to the value of the pledged collateral. The e¤ort level that the
producer puts in is therefore:
e=
A(1 + 4)
4
2
(34)
which is below the …rst best level. Notice that this result does not depend
on the security of collateral –n . The oborrower’s and the lender’
n s expected
o
2
2
A(1+4)
A(1+4)
1
payo¤s are, respectively: u
w(1
) and
+
4
2
2
w(1
)
:
1 2
For trade to take place on these
terms, we
require that u
A . This
4
h
i
A2 (1+4)2
will happen when w(1
)
1
!.
4
4
When the outside option is a binding constraint, then r will be determined
by:
2
A(1 + 4) (r w(1
))
1
w(1
) = A2 :
(35)
2
4
This yields
r = A(1 + 4)
r
2
A2
+ w(1
4
) + w(1
(36)
);
2
with e¤ort equal to A4 + w(1
).19 Now e¤ort is a (decreasing) function of
the security of collateral.
We can now de…ne precisely when pledgeable wealth is a constraint on
economic e¢ ciency. This will be the case
q if wealth is insu¢ cient for the …rst
A2
4
best e¤ort level to be attainable, i.e.
w(1
)
+ w(1
A2
(1 + 4)2
4
A(1+4)
2
)
1
or,
(37)
!:
If w(1
) > ! then we have a …rst best outcome. Evidently, this requires
that the availability of illiquid assets (w) has to be large enough. However,
19
In this case:
r
A2
=
+ w(1
4
) A(1 + 4)
r
2
22
A2
+ w(1
4
!
)
+ w(1
)
:
this is not su¢ cient – must also be far enough away from one. An economy
is constrained by property rights when w
! > w(1
). For ! > w
imperfect property rights increase the existing level of ine¢ ciency, while for
) imperfect property rights create new ine¢ ciencies.
w ! > w(1
As in previous sections, we turn our focus now to what happens when
changes marginally. Our simple set-up allows us to get a complete understanding of the comparative statics of the optimal contract. Our main result
drops cleanly out of the analysis.20
Result 2.5 For w(1
) 2 [!; !], the interest payment, r, is lower and
producer e¤ort is greater after a marginal increase in the security of
collateral which increases the level of pledgeable wealth, w(1
). For
) > !, marginal improvements in the security
w(1
) < !, or w(1
of collateral do not a¤ect resource allocation (i.e., loan size and e¤ort)
in the credit market. However, in the former case, it has a redistributive
e¤ect with lenders gaining relative to borrowers.
The result captures the mechanism suggested by de Soto (2000) linking
property rights that increase the use of collateral and e¢ ciency. However,
it also makes precise the range of illiquid wealth for which this argument
is relevant. If wealth is very low, i.e., w(1
) < !, then the outside
option constraint is not binding. In this case, the terms of the contract
are a¤ected by improvements in property rights, but there is no increase in
e¤ort conditional on credit being granted. However, improvement in property
rights eases the constraint of transferring resources from the borrower to
the lender, and this bene…ts the lender at the expense of the rent that the
borrower gets. Improving property rights have a purely redistributive e¤ect
in this case. Similarly, if wealth is very high, the resource allocation is
already e¢ cient at the …rst-best level, and therefore, marginal improvements
in property rights will not have any e¤ect.
The upshot of this discussion is that even where there is a “de Soto
e¤ect” on e¤ort observed (or, loan size), we would expect that e¤ect to be
heterogeneous with @e=@ being proportional to illiquid wealth w. Those
with larger levels of illiquid wealth will respond more strongly to a given
improvement in property rights. However, beyond the pledgeable wealth of
!, the e¤ect again becomes zero.
20
Formally, the result follows by taking the derivative of r with respect to and observing
2
that A4 + w(1
) = e 1.
23
This illustrates the importance of modeling in seeking to study the impact
of property rights improvements on economic outcomes through the collateral
channel. Looking for an average e¤ect across a group of producers with
heterogeneous wealth could well underestimate the impact which we would
expect to …nd only in the middle wealth group.
There are also implications for looking at the e¤ect of improving property
rights in aggregate data. The size of the gains from reducing will depend
on the distribution of wealth. In particular, in very rich, very poor, or very
unequal societies (comprising only very rich or very poor) the overall e¤ect
will not be large.
Our model can also highlight another set of e¤ects that have been largely
ignored in the empirical and theoretical literature to date. So far our analysis
has not considered how changing property rights a¤ects the structure of
the credit market and who trades with whom. To illustrate this, suppose
that there are many potential lenders who vary in their opportunity costs of
capital, , determined by their access to loanable funds:
A simple way into thinking about this is to consider a two-sector model
using the labels formal and informal to describe the lenders. In the formal
sector, there is a common transactions technology 1 F and access to funds
= F : We imagine that producers are also connected to potential lenders
through social networks in which case they face property rights enforcement
1
N and lenders with cost of loanable funds N . The most natural and
interesting case to study is where F > N and F < N . This says that
formal lenders have better access to loanable funds while the informal sector
is better at enforcing contracts. If networks had both lower and lower
then they would clearly dominate the formal sector.
We will not provide a complete treatment of how people are assigned to
the two sectors – that would require a more involved analysis than can be
undertaken here. Instead, we will look at some of the issues that arise as
property rights change. The analytical change that is needed to study this
is to recognize that the relevant outside option for a producer may no longer
be 41 A2 but trading with another lender.
Suppose (somewhat unrealistically) that both networks and markets are
competitive so that lender rents are bid to zero in each. Then it is straight-
24
forward to show that the level of producer utility is:
q
2
A (1 + ) + [A (1 + )]2 + 8 [w (1
i)
U ( i; i) = 4
4
i]
32
5
w (1
i)
(38)
where i 2 fF; N g. We assume ui > 14 A2 because, otherwise given (26) no
trade will take place. In this competitive world, we would expect the producer
to match with the lender for whom this zero pro…t utility is greatest. Thus,
the formal sector will dominate if U ( F ; F ) > U ( N ; N ). It is clear now
that improving formal sector property rights can potentially lead to a move
from networks to formal lending as F falls. Since e¤ort is now set by the
p
2
A(1+ )+ [A(1+ )]2 +8[w(1 i ) i ]
, moving to a
outside option and is equal to
4
more e¢ cient producer now leads also to greater e¢ ciency. This is a general
equilibrium response to an improvement in property rights allowing trade to
prosper in its most e¢ cient form. It is related to the e¤ect identi…ed in
section 2.2.1. However, it is now the e¤ect of improved property rights to
allow superior trade in another market, the credit market, that drives the
result.
There are other possible general equilibrium e¤ects to consider if we move
away from the perfect competition story. In the other extreme suppose that
there is a single network lender and a single formal sector lender. Each gets
to propose a contract to a producer and she picks her preferred outcome.
In this case, the reservation outcome is now set by the outside opportunity
available either in autarky or else by trading in the other sector. Suppose
that the latter is the case. In this case, a producer who chooses to trade
in a network will be a¤ected by an improvement in formal sector property
rights even if she chooses not to obtain credit in the formal sector. This is
because of a pure outside option e¤ect. Improving formal property rights
now, through this route, increases e¤ort in the network. However, if trading
in the other sector does not provide a good enough outside option (e.g., the
borrowers are poor, or the cost di¤erence is large), then an improvement in
property rights will bene…t the lender and hurt the borrower without having
any e¢ ciency e¤ects, as discussed earlier.
Finally, there is the possibility that improving property rights increases
competition.21 To see this, we need to suppose that there are di¤erent possi21
See Besley and Ghatak (2008) for further discussion of this.
25
ble levels of F with some formal sector …rms being more e¢ cient. Suppose,
for example, there is no informal sector, but two formal sector lenders with
di¤erent levels of F but the same level of F . Suppose that the cost di¤erence between the two lenders and the level of F are such that the higher cost
formal sector lender cannot provide any competition to the lower cost lender,
and autarchy is the only outside option of a borrower. A further e¤ect of
improving F can now be to induce entry in the formal sector increasing the
outside option of the producer. This leads to a redistribution of surplus from
the e¢ cient formal sector producer to the producer. But it also increases
e¢ ciency by increasing the outside option of the producer. This will increase
producer e¤ort.
The latter e¤ects that we have identi…ed come from thinking about how
the improvement of property rights a¤ects the set of potential trades that can
be sustained between lenders and producers. One feature of formal sector
enforcement is that it is a freely available contracting technology, whereas the
N is available only for trades between people who know each other. When
considering property rights that improve trading possibilities the bene…ts
from the creation of formal property rights may in signi…cant measure be
due to the fact that these are widely available, i.e. to all producers rather
than just those who are socially connected. This highlights a potential
downside in the use of networks in enforcing trade.
2.3
Optimal Assignment of Property Rights
So far we have discussed how insecure property rights impede e¢ ciency by
undermining investment incentives, and creating barriers to trade. Consequently, our analysis has focused on the channels through which making
property rights more secure for the producer will improve e¢ ciency. This implicitly assumes that the initial assignment of property rights to the producer
is optimal.
In this section, we question this and discuss the role of property rights
in assigning ownership to an asset to maximize its productive potential. We
have already looked at one aspect of this issue in section 2.2.1 where we
allowed for the possibility that the current owner may not be the most e¢ ciency potential user of an asset. The aspect that we address here allow for
the possibility that more than one party can invest to improve the productivity of an asset. Our discussion of these issues is based on the literature on
the property rights approach to the theory of the …rm developed in Grossman
26
and Hart (1986) and Hart and Moore (1990).
2.3.1
Optimal Ownership of an Asset
We extend our benchmark model above by considering two individuals, A
and B, who undertake investments eA and eB that, in combination with
p
p
the asset, generate returns a eA + b eB : The costs of these investments to
A and B are, respectively, eA and eB : The terminology “investment” here
as opposed to “e¤ort” in the last section emphasizes the durability of the
activity. We have in mind that the e¤ort undertaken by each party creates
something which is potentially of value to the future output from the asset
even if the party who makes the decision is separated from the asset.
The …rst-best levels of these investments are:
eA =
b2
a2
and eB = :
4
4
(39)
The associated total surplus is:
1
S = (a2 + b2 ):
4
(40)
Without any contracting problems, ownership does not have allocative implications, i.e. a contract can be written in which investment levels feA ; eB g
are prescribed.
The key insight of the property rights approach is that ownership matters
due to contractual incompleteness. In this example, the owner has some
bargaining power as he can threaten to exclude the other party from using
the asset (i.e., he can “…re”the other party and exclude him from the returns
from his investment). Ownership is now di¤erent from residual claimancy of
a pro…t stream: it is the residual control right over the asset.
If the owner of an asset rents it out to someone, the tenant has residual
claimancy. However, the owner retains the right not to renew the lease.
This will potentially a¤ect the incentive of the tenant to improve the asset.
It is these residual control rights that give the owner a bargaining advantage
over the non-owner.
As we shall see, this improves investment incentives for the owner while
worsening them for the tenant. The optimal assignment of ownership takes
into account how important are the investment decisions of each party and
how severe is the hold up problem from having each party not owning the
27
asset. The term hold-up here refers to the fact that the owner can limit the
value of an investor’s input to the project by …ring him ex post.
To illustrate these arguments more precisely, assume that eA and eB are
observable but non-veri…able. The last of these assumptions implies that
a court could not enforce stipulated e¤ort levels as it would be impossible
to verify whether they were implemented. Thus investment levels are noncontractible ex ante. The two parties are assumed to bargain over the ex
post surplus once it has been created.
Suppose …rst that party A is owner. Then at the bargaining stage, he
has the right to …re B: Let uji denote the disagreement payo¤ or outside
option of i when j is the owner. We assume that even if A …res B at the
bargaining stage, he can still make some use of the results of B’s investments.
Speci…cally, a fraction of the investment remains to be exploited by A in
B’s absence. It is useful to think of as measuring the extent of asset
speci…city. In the model of the previous section where eB would be generic
“e¤ort” then = 1. However, where there is something special about B’s
human capital which requires his continued involvement in the project to
make the most of it, then < 1.
Putting this together, the outside options of the two parties are uA
A =
p
p
A
a eA + b eB and uB = uB where uB is the exogenously given level of the
disagreement payo¤ of B: Using the symmetric Nash bargaining formula,22
the ex post payo¤ of A is:
p
1 A
1 p
(a eA + b eB ) +
u A uA
(41)
B
2
2
p
p
which simpli…es to a eA + 12 (1 + )b eB u2B : Similarly, the ex post payo¤
of B is
p
1 A
1 p
(a eA + b eB ) +
u
uA
(42)
A
2
2 B
p
which in turn simpli…es to 12 (1
)b eB + u2B :
22
This is standard in the literature following Grossman and Hart (1986). The transfers
solve:
t
=
p
p
arg maxf a eA + b eB uA
A
p
p
a eA + b eB uA
+
t
g:
B
28
t
The two parties will choose eA and eB at the ex ante stage anticipating
the ex post payo¤s derived above. As a result the optimal choice of these
variables are
b2 (1
)2
a2
B
=
=
and
e
^
:
(43)
e^A
B
A
4
16
This yields a second-best net expected surplus of
b2
a2
+ (1
S^A =
4
16
)(3 + ):
(44)
This is less than the …rst best surplus S .23 Since B anticipates that, after
the investments are made, he will be at the mercy of A, he invests less than
the …rst best level. The higher is , the less costly it is for A to …re B and
the greater is the incentive problem of B: However, if = 1, there is full
exploitation of B’s output and he does not invest at all. If we think of as
representing the extent of specialized skills, then economies with greater skill
intensity will su¤er a smaller e¢ ciency loss through this e¤ect than those
which only have generic labor input.
There are symmetric expressions if B is the owner. We now use 2 [0; 1]
to be the investment speci…city parameter analogous to . By a similar
analysis we …nd:
a2
b2
2
B
B
(45)
1
e^A =
and e^B = :
16
4
Second best surplus (also less than S ) is:
a2
S^B = (1
16
) (3 + ) +
b2
:
4
(46)
As before, a larger value of induces a greater e¢ ciency loss, all else equal.
We can now which party should own the asset to maximize economic
e¢ ciency (measured by total surplus) as a function of the key parameters:
a; b; ; and : Comparing (44) and (46), we …nd that A should owner the
asset if if a2 (1 + )2 > b2 (1 + )2 ; while B should own it otherwise. We state
this …nding as:
Result 2.6 If the marginal return of A’s ( B’s) investment is greater than
that of B’s ( A’s) or his investment is more asset-speci…c than B’s
23
Observe that (1
)(3 + ) is strictly decreasing in . Also, it takes the value 3 for
2
b2
b2
^A
= 0 and the value 0 for = 1: Hence, 16
(1
)(3 + ) 3b
16 < 4 implying that S is
less than S .
29
( A’s), under the e¢ cient assignment of property rights A ( B) should
own the asset.
This theory of the “optimal”allocation of property rights can be thought
of as re‡ecting two dimensions of the skill of the investors. The parameters a
and b re‡ect their relative productivities as investors with a presumption that
the most productive should own the asset. But the speci…city of their skills
matters too. If one investor has a very specialized skill so that replacing
him would lead to a major loss in output, then it is best that he owns the
asset. If not, the investment process is more prone to hold-up. So if one
party supplies generic e¤ort which stays with the project whether or not he
leaves, he will generally not optimally be the owner.
These ideas apply to thinking about ownership structures in agriculture
in developing countries where landlords and tenants both have skills that can
play a role in improving the land. The land should optimally be sold o¤ to
the tenant if the latter is more productive and has more land speci…c skills
than the landlord. We now consider tenancy issues in more detail in light
of this insight.
2.3.2
Role of Tenancy
The model in the last section predicts that tenancy is an e¢ cient arrangement
when the landlord has high productivity and a high level of asset speci…city.
But in many contexts, the …rst of does not seem prima facie reasonable. The
persistence of tenancy would then seem more plausibly due to the fact that
credit market imperfections prevent the transfer of the land to the tenant.
There could also be other bene…ts to holding land such as linked bene…ts in
the form of patronage or political power which make the land more valuable
to the landlord and mean that he would always outbid the tenant for the
land in an auction.
To explore this, we will suppose that A is the landlord, but a = 0 so
that B should optimally be the owner. The value of the asset when A is
b2
(1
)(3 + ) and since B’s outside option is uB , A’s
the owner is S^A = 16
A
^
payo¤ is S
uB and B’s payo¤ is uB : If B is the owner, the value of the
b2
B
^
asset is S = 4 . If B had the ability to make up-front payments, there are
gains from trade. For example, if the transfer price p is set at S^B S^A then
A is strictly better o¤ and B is no worse o¤ when ownership is transferred to
B: But if B has no liquid funds, then this transfer will not take place. The
30
arrangement that prevails will then resemble a share tenancy where B gets
a 50% share of output.
It might be possible for a third-party (a bank) to enable B to buy the
asset. To keep things simple, suppose that the interest rate is normalized to
zero and B will simply have to pay back p to the lender. The problem now is
that B will be in the same situation vis a vis the bank as he was previously
vis a vis the landlord. So there is no gain in transferring ownership to a
di¤erent unproductive party.
A land reform that transferred ownership to party B would now raise
productivity. In fact, this is true for any land reform that dilutes the landlord’s rights. To see this, suppose that with probability 2 [0; 1] the tenant
(party B) will acquire the land. This is similar to the way that we modeled
attenuated property rights in in section 2.2.1. Now with probability (1
);
p
uB
1
)b eB + 2 but with probability
B’s ex post payo¤ is as before, i.e., 2 (1
p
it is b eB as A has been expropriated via the land reform. Now
e^A
B =
1
(1
2
)(1
)+
b2
:
4
(47)
When = 1 this coincides with the outcome under pure B-ownership and
when = 0 it coincides with the outcome under A-ownership. Party B’s
investment is increasing in : We now have:
Result 2.7 In the presence of frictions that prevent the e¢ cient allocation of property rights, transferring property rights to the tenant will
increase e¢ ciency. Greater security of property rights for the initial
owner now reduces e¢ ciency.
This result underpins the classic argument for forcible land redistribution
towards tenants. That insecure property rights of one party (here the landlord) may enhance productivity is an application of the theory of the second
best. Given that ownership is ine¢ cient due to imperfect capital markets, a
second distortion (imperfectly enforced property rights) can be e¢ ciency enhancing. This result relates to the large literature on tenancy showing that
redistributive reforms such as land reform or tenancy reform might improve
productivity and that the standard e¢ ciency-equity trade o¤ need not apply
in all cases.24
24
See Banerjee et al (2002) and Mookherjee (1997).
31
There is a link between this analysis of optimal property rights and the
discussion of insecure property rights in the previous section. The producer
in the benchmark model above could be thought of as the “rightful” owner
(from the e¢ ciency point of view) and the insecurity in the form of as
therefore arising out of an ine¢ cient allocation of property rights. Since the
coercive authority cannot commit not to expropriate the producer, there is
an ex post hold-up problem and as a result of this the producer only gets a
fraction of the share of the results of his investment. It is therefore ine¢ cient
if the coercive authority ends up owning the land. In section 3 we will
examine this issue in greater detail.25
2.3.3
Communal Property Rights
The model developed so far looks solely at individualistic property rights.
But it is often argued that communal property rights can, under some circumstances, be superior (see, for example, Platteau, 2000). One way to
think about communal property rights is that they maximize joint surplus
because consumption is shared among members of the community. In that
case, by assumption, communal tenure will always achieve the …rst-best. This
is not entirely plausible since the evidence of communal property rights does
not provide unambiguous support to this view. For example, the well documented increase in agricultural productivity in China after switching to a
household responsibility system seems to go against this …nding.26 A more
promising approach would be to examine under what circumstances communal property might achieve greater e¢ ciency than individual property rights.
In the above framework, communal property rights are best thought of as
joint-ownership in the sense that, if there is a disagreement at the bargaining
stage, then production cannot go ahead. In other words, both parties have
veto power (this is how joint-ownership is modeled in Hart, 1995), i.e., the
disagreement payo¤s of both parties are zero. In this case, it would seem
likely that the hold-up problem would be worse than with either party owning
the land individually.
To examine this formally, observe that, using the symmetric Nash barHere we assume symmetric Nash-bargaining and therefore = 21 : However, if we use
asymmetric Nash-bargaining then can be any non-negative number between 0 and 1 and
will re‡ect the relative bargaining power of A:
26
See, for example, Lin (1988, 1992).
25
32
gaining formula, the ex post payo¤ of both A and B is now
p
1 p
(a eA + b eB ) :
2
2
(48)
Then the investment levels are e^JA = a16 and e^JB =
net expected surplus is
3a2 3b2
+
:
S^J =
16
16
b2
;
16
and the second-best
(49)
It is straightforward to see that this level of surplus is less than both S^A and
S^B : In other words, joint-ownership is dominated by individual ownership.27
As conjectured, joint-ownership exacerbates the hold up problem.
But this negative conclusion on the merits of communal property rights
depends on the output being a purely private good. To see this, suppose
instead that the good produced is public so that, even if one of the parties
is excluded by the owner, he is still able to enjoy some of the bene…ts. This
might be, for example, be because there are features of the asset that are enjoyed in common. More generally, any investments that improve the quality
of an asset might spillover in part to neighbors.
The following extension of the model to public goods is based on Besley
and Ghatak (2001) which extends the property-rights approach to the case
of pure public goods. They show that joint-ownership may dominate private
ownership in this case.
To illustrate the argument, consider the following simpli…ed version of
the above model. Suppose that a = 0 implying that, if this was a private
p
good, then B should be the owner. Suppose that the output b eB is now a
pure public good and A and B are the valuations of that good of parties A
and B: The joint-surplus maximizing level of investment is now given by:
eB = arg maxf(
eB
A
+
B) b
p
eB
eB g =
b2 (
A
+
4
2
B)
:
(50)
A key distinction from the private good case is as follows. Since the
output is a pure public good, then even if bargaining breaks down, the owner
cannot exclude the other party from enjoying the bene…t of it. Therefore,
p
p 28
B
under B ownership uB
A = A b eB and uB = B b eB .
27
This result holds more generally, for example, when the investments are complementary (see Hart, 1995).
28
We have set uB = 0.
33
b2
2
B
As a consequence, the choice of investment is given by e^B
: UnB =
4
p
p
B
B
der A-ownership uA = A b eB and uB = B b eB : Hence, the choice
n
o2
(1+ )
(1 )
b2
of investment is given by e^A
=
+
: In contrast, unB
A
B
4
2
2
der joint ownership uJA = uJB = 0 and the choice of investment is given by
2
e^JB = b4 ( B +2 A )2 : If A > B then both ownership by A and joint-ownership
dominates ownership by B . This contrasts with the case of a purely private
good. Moreover, if > 0; joint-ownership dominates ownership by A.
We summarize this result as:
Result 2.8 When the output produced with the asset is a public good, then
communal property rights (joint ownership) may sometimes be optimal.
The intuition behind this result is simple. Joint-ownership “ties down”
the two parties to the project and hence minimizes free-riding which is a
problem for the provision of public goods.
Property rights allocation in the case of partly private and partly public
goods has not been investigated much in the literature. However, it does
seem relevant for understanding some forms of organization, especially in
the context of communal assets such as condominium housing arrangements.
This analysis suggests that, in general, the greater is the public good component in production, the more likely joint-ownership will dominate individual
ownership.
2.4
Evidence
This theoretical analysis naturally gives way to thinking about how property
rights a¤ect resource allocation in practice. There is now a signi…cant literature which looks at this.29 However, it is fairly rare to link the empirical
analysis closely to the theoretical channels that we have analyzed so far.
One issue is what outcome to focus on. In a reduced form sense, all of
the theoretical channels identi…ed above would suggest a link between the
level of output and property rights. In all cases, the level of investments,
in the stylized model e, is (weakly) higher when property rights are more
secure. However, as we showed in the example of guard labor, there can
also be a re-allocation of e¤ort to or from more productive activities.
29
See Pande and Udry (2005) for a comprehensive review of this literature.
34
The two trade channels are quite speci…c in the way that they suggest that
improved property rights will have an impact. In the …rst case, we should
see a deepening in rental or sale markets for assets. In the second, we should
see more use of credit among those whose property rights to collateralizable
assets are improved. To investigate these ideas empirically requires going
beyond looking solely at the e¤ects on output, although we would expect
output to be higher in both cases too.
One further issue concerns the level of aggregation. Our theoretical
examples focused on a speci…c producer with …xed characteristics. These
models mostly predict that the e¤ect of improved property rights will be
heterogeneous. To illustrate, consider the basic freedom from expropriation
argument. In this case:
@e
=
@
) A2
(1
2
:
(51)
This implies that factors that make A heterogeneous across producers such as
wealth, access to other inputs and/or markets will tend to a¤ect the marginal
e¤ect of an improvement in property rights. Such heterogeneous e¤ects are
a natural consequence of bringing theoretical considerations to bear on the
analysis of the data.
We might also expect macro-economic and micro-economic impact e¤ects
to be di¤erent in so far as the former capture general equilibrium responses
to improvements in property rights. The overall macro e¤ect can mask many
underlying mechanisms as emphasized here.
Another issue in bringing these ideas to the data concerns how to capture
property rights. Our simple theoretical parameter, , masks a whole range
of possibilities. In micro-data, it is frequently possible to be quite precise
about the claims that people have to their assets. For example, some asset ownership is backed by o¢ cially recognized and registered title deeds.
However, other property is held more informally. A good example is the
case of land rights in Ghana where land rights are granted by tribal authorities. Moreover, the rights to each plot of land are quite heterogeneous. In
the data used in Besley (1995), rights can be decomposed into the di¤erent
components –buying, selling, renting, leasing and pledging.
The key issue whether in micro or macro data is how to identify the causal
e¤ect of changes in property rights on investment or productivity. Macroevidence tends to look at countries as units of analysis, sometimes regions
within countries. Micro-evidence looks at the e¤ect of property rights using
35
data on …rms and/or households. The core empirical approach is to run
some kind of regression of the form:
yit =
+ rit + xit + "it
(52)
where yit is a measure of an outcome for cross-sectional unit i at date t, rit
is a measure of property rights and xit are appropriate controls and "it is an
error term.
In the basic case, there is no time dimension to this kind of analysis and
the e¤ect of property rights on outcomes is driven entirely by the fact that
some …rms or households appear to have better access to rights than others
at a point in time. This raises quite di¢ cult issues in estimating . Omitted
variables could be driving a simple correlation between the two: for example,
better governance could be driving both secure property rights and a more
investment-friendly environment. The other issue is that of reverse causality:
investment itself could a¤ect the nature of property rights.
In principle, either of these problems could be dealt with using instrumental variables, i.e. …nding a determinant of rit which is not also a determinant
of the decision of interest xit . This is the approach of Acemoglu, Johnson
and Robinson (2001) in their study of cross-sectional country di¤erences in
property rights. They argue that settler mortality drives expropriation risk
without having any direct impact on modern day income per capita. In
general, however, it is di¢ cult to …nd convincing instruments even in microdata.
In some cases, there are changes in rights over time and space which allow
researchers to explore the implications of changes in rights before and after
with an explicit time dimension. Whether this succeeds in dealing with the
issues of omitted variables and reverse causation is moot. This still depends
on how the rights are allocated to households or …rms. There may be scope
for …nding ways of explicitly modeling the political and economic forces that
shape rit .
Another route is to exploit variation between rights “within” …rms or
households. Thus, Besley (1995) exploits the fact that households in Ghana
enjoy di¤erent rights on di¤erent plots of land that they farm and is able to
look at how economic decisions vary across plots. This means that variation
in household characteristics that a¤ect the power of households to enhance
their rights are not spuriously driving the relationship between economic
outcomes and property rights.
36
Either way, this brief discussion emphasizes the need to understand the
reasons why property rights di¤er in di¤erent times and places. This is
something that we turn to in section 3.
It is possible to take a bird’s eye view of the quality of property rights
using cross-country data. To illustrate, we take two measures of property
rights regimes using standard sources. The …rst is a measure of the security
of property rights from the International Country Risk Guide (ICRG). It is
measured on a scale between 0 and 10. A higher score corresponds to better
protection of property rights. Figure 1 shows that this score is positively
correlated with income per capita in the year 2000. In other words, countries
with a higher risk of expropriation have lower levels of income per capita.
The second measure comes from the World Bank doing business project
(www.doingbusiness.org). We focus on a measure of the ease with which
individuals can register their property, speci…cally the country’s rank on this
measure for 172 countries. This is a purely administrative dimension to
property rights and follows the logic of the de Soto argument discussed in
section 2.2.2. Figure 2 shows that this too is strongly negatively correlated
with income per capita in 2000. Thus, this more administrative dimension
of property rights is weaker in low-income countries.
Together these …gures illustrate the central proposition that improving
property rights is associated with economic development. However, they
say nothing about the direction of causation.
The correlation in Figure 1 is intriguing and forms the basis of the wellknown empirical analysis of Acemoglu, Johnson and Robinson (2001) who
argue that this relationship is indeed causal. To this end, they use the mortality rates of colonial settlers as an instrument for property rights showing
that the negative relationship between the ICRG expropriation risk measure
and income per capita remains. Acemoglu and Johnson (2005) look at two
di¤erent dimensions of property rights and how they a¤ect growth –expropriation risk and contract enforcement. Their aim is to assess which is more
important in a¤ecting aggregate output. They use the identity of the colonial power as an instrument for contracting institutions and settler mortality
as the instrument for expropriation risk. On this base, they argue that only
expropriation risk holds up as causal factor in a¤ecting income per capita
while the contracting environment a¤ects the form of …nancial intermediation. In a related contribution, Glaeser et al (2004) argue that human capital
could be a key missing variable in this kind of analysis, jointly determining
both institutions and growth. However, given the scarcity of plausible instru37
ments, it is clearly di¢ cult to be able to identify between many competing
potential causal pathways in cross-country data.
There are several micro-empirical studies that look directly at the question of whether secure property rights improve investment incentives. Here
we provide a brief and selective review of the key …ndings. Besley (1995) in
his study of property rights in Ghana, mentioned above, exploit the variation
in the rights that individuals enjoy on di¤erent …elds to test whether property rights matter for investment decisions. Ghana is in a transition between
a traditional system of land rights (which emphasizes claims of the community) and a modern one (which emphasizes the claims of the individual
and grants ability to transfer the land without needing a community sanction). The study focuses on self-reported transfer rights: whether each …eld
owned and operated by a household has any of these rights is measured in
the data, along with whether exercising this right requires lineage approval.
In his study of the cocoa growing region, Wassa, in the west of the country,
where the investment decision is the decision to plant trees, he …nds that
controlling for household …xed e¤ects, investment is increased by better land
rights. The study takes into account the potential problem of reverse causality: investment decisions (e.g., planting trees) could a¤ect security of tenure
as well. The basic result holds if land rights are instrumented with …eld level
characteristics (soil quality, distance from house, investments already made
when land acquired). As to which mechanisms linking property rights to
investment are at work, this study is unable to …nd strong support for any
particular mechanism, but on the whole, the support is the weakest for the
collateral-based view.
In a more recent study on Ghana, Goldstein and Udry (2008) exploit the
variation in security of tenure within the system of informal property rights
administered by the local political system. They …nd that those cultivators
without political power (e.g., those who do not hold any form of local political
o¢ ce) are less con…dent of their rights. Compared to those who hold political
o¢ ce, they leave their land fallow for signi…cantly shorter duration (for fear
that the land will be allocated to someone else), resulting in signi…cant loss
in pro…ts per unit of land.
In a related study Field (2007) …nds that property-titles issued in Peru
starting in the mid-nineties led to a signi…cant increase in labor supply by
urban slum dwellers. The study looks at the e¤ect of the programme undertaken by Peruvian government that issued property titles to 1.2 million
urban households during the 1990s on labour supply. While it does not di38
rectly look at the e¤ect of investment, a key mechanism postulated in the
paper is that secure property rights reduced the need for guard labour and
this freed up labour time that could be e¢ ciently supplied in the labour
market. In a related paper Field (2005) looks directly at investment and
shows that residential investment also went up signi…cantly, using a similar
identi…cation strategy and retrospective data on housing construction.
A more recent study (Hornbeck, 2008) shows that the introduction of
barbed wire fencing to the American Plains in the late 19th century led to
signi…cant increases in the value of farmland, the productivity and production share of crops most in need of protection. Farmers were required to
build fences to secure their land. From 1880 to 1900, the introduction and
universal adoption of barbed wire reduced the cost of fencing, relative to
wooden fences, most in counties with the least woodland. Over that period,
counties with the least woodland experienced signi…cant agricultural development and according to this study, this appears to re‡ect increased security
of property rights due to barbed wire fencing.
Galiani and Schargrodsky (2005) is one of several studies that looks at the
collateral e¤ect of property rights reform. It focuses on urban squatters in
Argentina. Given that the allocation of titles was unlikely to have been random, they exploit a data-set which permits a cleaner identi…cation strategy.
They look at a group of squatters who occupied an area of wasteland in the
outskirts of Buenos Aires more than 20 years ago from the time of the study.
The area was composed of di¤erent tracts of land, each with a di¤erent legal
owner. An expropriation law was subsequently passed, ordering the transfer
of the land from the original owners to the state in exchange for a monetary
compensation, with the purpose of entitling it to the squatters. However, only
some of the original legal owners surrendered the land. The parcels located
on the ceded tracts were transferred to the squatters with legal titles that
secured the property of the parcels. Other original owners, instead, are still
disputing the government compensation. As a result, a group of squatters
obtained formal land rights, while others are currently living in the occupied
parcels without paying rent, but without legal titles. Both groups share the
same household pre-treatment characteristics. Moreover, they live next to
each other, and the parcels they inhabit are identical. Since the decision of
the original owners of accepting or disputing the expropriation payment was
orthogonal to the squatter characteristics, the allocation of property rights
is exogenous in equations describing the behavior of the occupants. This assumes that this decision is orthogonal to land quality which seems reasonable
39
in their context.30
They …nd signi…cant e¤ects on housing investment, household size, and
child education. The quality of the houses is substantially higher in the titled
parcels. They only …nd modest e¤ects on access to credit markets as a result
of entitlement, and no improvement in labor market performance. This is
not surprising, as squatters could not transfer the property parcels for the
…rst ten years. They do compare early and late treatment households and
…nd that 4% of the early treatment group received a mortgage loan. Their
conjecture is that this small e¤ect could be driven by di¢ culty of foreclosure
on default.
Another study by Field and Torero (2006) looks at an urban land titling
program in Peru. Their data allow them to directly observe whether loan
applicants are requested to provide collateral. As a result they can isolate
the e¤ect of property titles on credit supply from their e¤ect on demand
by comparing loan approval rates when titles are requested to rates when
they are not. Their results indicate that property titles are associated with
increase in approval rates on public sector loans by as much as 12% when
titles are requested by lenders. But they …nd no relationship between titles
and approval decisions otherwise. In contrast, there is no evidence that titles
increase the likelihood of receiving credit from private sector banks, although
interest rates are signi…cantly lower for titled applicants regardless of whether
collateral was requested.
One explanation for this failure is that titling programs reduce banks’
perceptions of their ability to foreclose. This is supported by data from Peru
indicating that individuals with title have less fear of losing property in cases
of default. Also, in Peru (and other comparable developing countries) even
the middle-level propertied classes don’t …nd it easy to receive credit. For
example, in Peru a minimum of two years of tenure in a formal sector job
and a high wage is a pre-requisite for receiving loans from the formal sector.
Therefore, it is not surprising that the urban squatters did not experience a
huge increase in credit supply.
Another possibility is that de Soto essentially assumes that the binding
constraint is always …nance (which one can obtain by pledging collateral).
But if a producer is in a low-return environment, either because of other
30
Di Tella et al (2007) study the formation of beliefs using the same data set and …nd
that lucky squatters who end up with legal titles report beliefs closer to those that favor the
workings of a free market. To the extent these beliefs encourage e¤ort and enterprise, this
could be an additional channel through which property rights might a¤ect productivity.
40
shortcomings in the institutional environment or market failures, collateral
is not going to do much good.31
However, more encouraging evidence is provided by Wang (2008) who
looks at a housing reform in China that allowed state employees who were
renting state-owned housing to buy their homes at subsidized prices. She
…nds that the reform increased the ability of individuals to …nance entrepreneurial ventures by allowing them to capitalize on the value of the property.
The implications of weak property rights have been studied using microdata on …rms. An interesting study along these lines is Johnson, McMillan
and Woodru¤ (2002) which uses a survey of …rms in post-communist countries. Their data exploit variation across …rms and from di¤erent country
institutional environments. They …nd that weak property rights do discourage …rms from reinvesting their pro…ts, even when bank loans are available.
Where property rights are relatively strong, …rms reinvest their pro…ts. However, weak property rights appear to deter entrepreneurs from investing from
their retained earnings.
3
Endogenous Property Rights
So why might property rights protection be weak? While historically, nonstate actors have played a key role in the creation and enforcement of rights,
in the modern world weak property rights boil down to problems in the
way that the state functions. There are three types of state failure that
are relevant to understanding this: predatory states, anarchic states and
ine¤ective states.
Predatory states are strong states that cannot …nd ways of limiting their
own power. Anarchic states are those where there is no single authority –
as when war lords and ma…osi retain coercive power.32 The power to enforce
or violate property rights is therefore fragmented.
Ine¤ective states are those which, although they may have established a
monopoly of force within a certain domain, have not invested su¢ ciently in
31
Our assumption (1) rules out the possibility that vis a vis projects with low expected
returns, collateral is not a binding constraint.
32
There is a large literature on private enforcement, i.e., when protection is provided by
pro…t-maximizing organizations (see Dixit, 2004), and also, some research on private institutions for property rights, including ones that …ght against predation by the government
(see Dixit, 2009).
41
relevant market supporting public goods such as courts and property registries. The …rst problem (predation) is an issue when the state is strong
while the latter two (anarchy and ine¤ectiveness) are characteristic of weak
states.
To date, most of the existing literature has focused on the …rst two problems. For example, Djankov et al (2003) pose the dilemma of e¤ective
government as …nding the right balance between the problem of predation
due to excessive state authority and anarchy due to weak state institutions.
We will argue in section 3.2 below that understanding the forces that shape
incentives to invest in market supporting property rights is also important.
3.1
Expropriation
There has been much discussion of aspects of state expropriation and arguments to the e¤ect that limiting coercive power of the state is an important
historical feature of state and market development (see, for example, North
(1990)). A classic reference is North and Weingast (1989) who argued that
a decisive point in the history of state development in England came after
the Glorious Revolution which limited the arbitrary power of the King subordinating his ability to raise taxes to Parliament. The need to limit state
power and hence protect property rights is also at the heart of Acemoglu,
Johnson and Robinson (2001)’s interpretation of why states with low rates
of settler mortality built more e¤ective states with more respect for private
property.
Models of states’incentives to exploit arbitrary power include Grossman
and Noh (1994), Grossman and Kim (1995), Moselle and Polak (2001) and
Olson (1993).33 It might be tempting to conclude that the problem of
excessive state power is only a feature only of models where the government
is controlled by a self-interested ruler intent on extracting resources from
its citizens. However, as Kydland and Prescott (1977) shows, it may be
optimal to limit state power even when the government is benevolent if it
cannot commit to a future policy.
Expropriations by government are a fact of historical experience as illustrated in Table 1 which gives some examples over seven hundred years of
human history. It begins with the expropriation of the Knights Templar
33
Discussions of private property rights enforcement include Grief (2005) and Skaperdas
(1992).
42
by Philip IV of France in 1307. Thereafter, we …nd other regular examples of sovereign power being used to seize assets. Henry VIII dissolved the
monasteries in England and took over the land beginning in 1536. The U.S.
government now widely regarded as paragon for upholding property rights
used expropriation as an instrument of public policy from 1870 onwards in
order to promote railway construction, milling and mining.
Natural resources have also …gured in government expropriations of the
past. President Cardenas of Mexico expropriated, among other things, petroleum assets in the 1930s. Iran expropriated oil production facilities in
1951. The Cuban revolution in 1959-60 also resulted in considerable expropriation of private assets by the state. Expropriation of land was the
particular objective of the Algerian government between 1971 and 1980. In
1971, the Chilean government expropriated U.S. copper mining assets reputed to be worth more than $500 million at the time. Such expropriations
continue to the present day as evidenced by the Zimbabwean government’s
program of forceful land redistribution since 2000.
All of these examples underline the contemporary and historical relevance
of the material that follows.
3.1.1
Framework
We begin with a simple framework that includes the benchmark model of
production from section 2.
There are N identical producers. Each producer produces x( ) y ( )+z
where y( ) is produced output, z is non-produced output (e.g., natural resources), and is the rate of expropriation. The pro…t function of a producer
is:
p
e
(53)
( ) = max (1
) A e+z
e 0
h
i2
2
with optimal e¤ort e ( ) = (1 2 )A and expected output y ( ) = (1 2 )A as
in section 2.1 above.
We now suppose that there are M coercive authorities who together determine – the rate of expropriation: At this level of abstraction, we can
think of such authorities in quite broad terms as states, powerful landlords,
feudal barons or roving bandits.
A coercive authority is distinguished by having access to a technology for
expropriating the output of producers. Let Tj be the resources committed to
expropriation by authority j. Collectively these actions determine the level
43
of expropriation experienced by producers. We model this for the moment
as a common resource problem with the aggregate expropriation rate being
=
M
X
Tj ;
(54)
j=1
the sum of the actions of the expropriating groups.34 This is a very speci…c
technology and one could consider others. But it serves to …x ideas about
some of the basic issues that arise when studying the equilibrium level of
expropriation.
Each coercive authority tries to capture a share of total output. We
assume that the expropriation rate is common across both types of output
and all producers, and hence expropriation cannot be targeted to speci…c
production activities.
Aggregate output is simply N times output per capita and is denoted by:
X ( ) = N [y ( ) + z] :
(55)
This is clearly decreasing in . For future reference, the aggregate produced output and natural resource output are Y ( ) N y( ) and Z
Nz
respectively: We now explore the determination of under di¤erent assumptions to investigate the kinds of factors that will lead to di¤erent levels of
equilibrium expropriation.
3.1.2
Commitment
We start by assuming that the coercive authorities can commit to an expropriation level up front. This is built into the following timing structure:
1. Coercive authorities choose T1 ; :::; TM :
2. Producers put in their e¤ort e.
3. Output is realized and expropriation takes place.
We now look at the equilibrium of expropriation as determined by a Nash
equilibrium between the coercive authorities. These could be thought of as
“roving bandits” in the sense of Olson (1993). The history of Europe is
34
We will make assumptions to ensure that
44
< 1 in any equilibrium.
replete with marauding groups such as the Vikings and the Magyars that
plundered from whatever sources they could …nd in the absence of a strong
sovereign. We assume that expropriation is costly and let N be the (constant) marginal cost of expropriation. We have made this increasing in N so
that having a large group of producers to expropriate is more costly. We
have also assumed that each producer has the same expropriation cost. This
can be motivated by supposing that N is equal to an outside wage determined by some kind of productive activity in which organizers of coercive
authorities can otherwise engage. Having a more productive economy will
then make expropriation more expensive.
The payo¤ of the j-th coercive authority is:
Tj (X ( )
N ) = N Tj (y ( ) + z
):
(56)
Thus the “pro…t” of a coercive authority comes from the outside wage rate
that determines the opportunity cost of expropriation. The trade o¤ for
coercive authorities is quite standard. An increase in expropriation increases
pro…ts assuming that y ( ) + z > , but leads to each producer lowering
his e¤ort. The optimal rate of expropriation balances these two factors. A
2
necessary condition for a positive rate of expropriation is that A2 + z > .
This says that there have to be su¢ cient resources to plunder relative to the
cost of expropriating. We assume that this is the case from now onwards.
The Nash equilibrium in expropriation levels has all coercive authorities
choosing Tj simultaneously. This yields …rst order conditions, assuming an
interior solution, of:
0
Tj y ( ) + y ( ) + z =
Tj A2 + (1
2
) A2
+z = :
(57)
Since all authorities have an identical expropriation technology, it is natural
to focus on a symmetric outcome. It is straightforward to show that the
overall expropriation rate ; assuming an interior solution, is then given by:
=
1+
2 (z
)
2
A
M
:
M +1
(58)
There are three immediate comparative static results that are straightforwardly derived for this simple problem and will serve to organize our thinking about the organization of coercion. These will look at how the level of
45
expropriation varies with the number of coercive authorities (M ), the level
of natural resources per producer (z) and the cost of coercion ( ).
Our …rst result comes from seeing how depends on M –the number of
coercive authorities. Totally di¤erentiating (58) yields
@
=
@M
1+
2 (z
)
2
A
1
> 0:
(M + 1)2
(59)
This yields:
Result 3.1 (Monopoly of Force) –Output is highest and expropriation lowest when there is a monopoly on coercive authority.
This result follows from the observation that competitive determination
of expropriation rates creates a commons problem. Each coercive authority
fails to internalize the e¤ect of its expropriation decision on others. States
that are fragmented, i.e. where coercive authority is wide spread will tend
to be poorer according to this logic. This corresponds to the kind of fragmentation that is frequently referred to in the context of weak states –see,
for example, the discussion in Acemoglu (2005).
This result goes back a long way. It underpinned Hobbes’ concept of
Leviathan and Weber’s concept of the state in which a single state authority
monopolizes the power to coerce. The simple model that we have set up
shows that this has a rationale in terms of e¢ cient organization of production.
Olson (1993) puts this point colorfully as follows:
“In a world of roving banditry there is little or no incentive
to produce or accumulate anything that may be stolen and, thus,
little for bandits to steal. Bandit rationality, accordingly induces
the bandit leader to seize a given domain ... and to provide a
peaceful order ... thereby obtaining more in tax theft than he
could in migratory plunder.”(page 568)
Just how monopoly of coercion can be achieved is not clear. One could think
in terms of a creating a state with the power to prevent all other actors in the
economy from exercising coercive power. This certainly represents the situation that we see in many advanced states in the world. But the monopoly
outcome could also be achieved by …nding some kind of Coasian arrangement
among those who possess the power to expropriate. These authorities could,
46
in principle, bargain with one another to achieve the monopoly outcome and
then use transfers among each other to achieve the cooperative outcome.
However, practical experience suggests that states that have broken down
…nd such cooperative outcomes quite di¢ cult to sustain.
One way to achieve an outcome equivalent to monopoly expropriation is
via a system of monopoly franchises (chieftains). A good example is the
Zamindari system of land taxation in India where powerful landowners were
given the power to expropriate from particular tenants. The “franchise”
arrangement can be thought as de…ning property rights by the coercive authorities. Let N j be the group of producers assigned by such property rights
to the jth coercive authority. Then the optimal expropriation decision maximizes:
Tj N j (y (Tj ) + z)
N j Tj .
(60)
This e¤ectively achieves the Coasian outcome among the chieftains by assigning property rights to the coercive authorities, thereby overcoming the
common pool problem.35 But there is an issue of how such rights are de…ned
and enforced in the absence of some kind of super coercive authority. In the
case of the Zamindars in India, it was the British who used them as agents
of colonial rule.
If there are many coercive authorities, then one issue is whether competition between them works as a further restraint on expropriation. This will
happen only if there is mobility of producers across coercive domains. One
feature of many low income economies is that such mobility is either naturally or arti…cially limited. Moreover, we would expect coercive authorities
to strategically limit mobility in order to maintain the power to expropriate
resources. Thus in many parts of Africa, systems of land tenure and passage of land across generations are set up to reduce mobility. This has a
short-term logic for those who operate such systems. However, in a dynamic
perspective, it clearly has a cost if expropriation levels are too high.
Our second result looks at how expropriation varies with the extent of
non-produced output (natural resources). Here, it is straightforward to see
that:
2
M
@
= 2
> 0:
(61)
@z
A M +1
This result can be interpreted as follows:
35
Note however, that this is not the …rst-best outcome: there is still the standard
distortion of an output-based transfer scheme.
47
Result 3.2 (Resource Curse) –A higher level of non-produced output leads
to more expropriation and hence less output overall.
This result is driven by the fact that such expropriation in this case does
not create any disincentive e¤ect. It mirrors a wide variety of empirical
…ndings suggesting that resource richer countries …nd it di¢ cult to establish
regimes in which expropriation is limited (see, for example, Sachs and Warner
(2001) or Mehlum et al (2006)).
Finally, we can look at the e¤ect of an increase in . This has at least two
possible interpretations. One sees it as re‡ecting improvement in outside
productive options among those who have the power to coerce. This would
be the case in a more productive economy where wages are higher. The
other is an improvement in systems of formal property rights protection,
for example by undertaking reforms of legal protection with an independent
judiciary to protect the rights of producers. This would make exercising
private coercive power more costly. Di¤erentiating (58) with respect to
yields:
2
M
@
=
< 0:
(62)
2
@
A M +1
This yields:
Result 3.3 An increase in the cost of coercion and/or the bene…ts to noncoercive activities increases produced output and reduces expropriation.
This result ties our model to some general equilibrium approaches to
rent-seeking in which coercive activity is a¤ected by the level of economic
development in general. Many authors have argued that a key role of institutions is to set the relative reward structures for di¤erent kinds of economic
activities. Baumol (1990) and Murphy, Shleifer and Vishny (1991) have
argued that entrepreneurial talent can be reallocated towards rent seeking
and organized crime when the returns to such activities are high relative to
producing. Even in advanced democracies, these authors emphasize that
the legal system can be a device for organized rent-seeking which reduces
production.36
36
A general equilibrium model of rent-seeking has also been developed by Acemoglu and
Verdier (1998).
48
3.1.3
No Commitment
The simplest way to capture the inability to commit in this model is to suppose that is chosen after the e¤ort decision by the producers. Throughout,
we study the case of a monopoly coercive authority and, for simplicity, set
= 0. The timing of moves that we consider is:
1. Producers put in their e¤ort e:
2. The coercive authority chooses .
3. Output is realized and expropriation takes place.
We consider a sub-game perfect Nash equilibrium in this game.
straightforward to see that in a one-shot setting we have:
= 1 and e = 0:
It is
(63)
This yields the obvious but important insight:
Result 3.4 Without commitment in a static setting, the level of expropriation is one-hundred percent and produced output is zero.
The logic is simple: for any y ( ) 0, the coercive authority will set = 1.37
Anticipating this, the producers will commit no e¤ort and produced output
is zero.
This …ts well the idea of a state that is “overstrong against thyself” following De Long (2000) who quotes the poet John Milton in this context. The
outcome in this equilibrium is Pareto ine¢ cient for low enough z. This is
because there is a level of expropriation < 1 which makes both producers
and the coercive authority better o¤ from an ex ante point of view. The
question is how to solve the commitment problem so that Pareto gains can be
reaped. Unless noted otherwise, to make things as stark as possible we focus
on the case where z = 0. We now explore …ve ways in which an outcome
with < 1 can be obtained: reputation, exit, secrecy, ownership, and voice.
37
Observe that if
that:
> 0 and z = 0, then the coercive authority can commit to ~ such
Y (~) = N .
If z > , then we get the same equilibrium as with
49
= 0.
3.1.4
Reputation
The fact that coercive authorities have an incentive to develop a reputation
for restricting the use of their expropriative activity is a central theme of the
literature on security of property. This has been applied to the problem of
limiting state power by Grossman and Noh (1994) among others. We illustrate this in the conventional way – thinking of producers and the coercive
authority as being in a long-run relationship. This means that the producers can “punish” the coercive authority for expropriating them excessively
by ceasing to produce for some speci…ed period. But for long-run relationships to work to secure property in the way that this suggests, it must be
that there is some long-run entity called the state that can take a far-sighted
view. Olson (1993) characterizes the state in such contexts as a “stationary
bandit”. The fact that the state is stationary means that it is able to take
a long-term view. He describes this idea as follows:
“A stationary bandit will therefore reap the maximum harvest in
taxes ... only if he is taking an inde…nitely long view and only if
his subjects have total con…dence that their “rights” to private
property ... will be permanently respected.”(page 571).
One feature that separates weakly and strongly institutionalized political
systems is the extent to which they have long-lived political institutions that
can be used to sustain reputational outcomes. For example, strongly institutionalized settings often have parties with long-term political ambitions
and hence an incentive to build reputations. Olson (1993) emphasizes that
this desire for the longest possible time-horizon was embodied in the familiar
refrain “long live the King”. Just how relevant these ideas are in practice, is
moot. Clearly forward-looking behavior has to apply across generations of
politicians. Moreover, the data suggest that, if anything polities with longlived politicians and parties holding o¢ ce tend to have less secure property
rights.
To study the role of reputation in the simplest possible way, suppose that
there is an in…nitely repeated interaction between the coercive authority and
the producers. There is production at each date and the coercive authority
chooses at each date. In such situations, the coercive authority can be
punished by producers if it chooses to expropriate them more than promised.
We solve the ensuing in…nitely repeated game by supposing that producers and the coercive authority use simple history-dependent stationary
50
trigger strategies whereby producers set e = 0 after any history of play in
which a coercive authority sets = 1. Let the promised expropriation rate
be ^ . We assume that producers set e = 0 after any history of play in
which the coercive authority chooses ^ <
1. We assume that the coercive authority discounts the future with discount factor 2 [0; 1]. This
could be interpreted in the standard way as a part of preferences or it could
be thought of as representing a “political”discount rate re‡ecting how likely
will be the turnover of the current government. We will study strategies
of expropriation that are credible in the sense that if a coercive authority
promises such a rate, it will be in its interest to honor that promise. Hence,
along the equilibrium path, there will not be any expropriation beyond the
promised level and producers will commit e¤ort levels consistent with this.
To see what levels of expropriation are sustainable, consider the “value
function” of the coercive authority after it has deviated to maximal expropriation, i.e. set = 1; following a “promised” expropriation rate of ^ .
As noted before, for simplicity we set z = 0; since producers are assumed
not to a¤ect the ‡ow of non-produced revenue, their behavior cannot change
depending on the actions of the coercive authority, on or o¤ the equilibrium
path. We will however comment later on how the results are a¤ected when
z > 0: The discounted expected payo¤ of the coercive authority following a
deviation is:
V (^) = Y (^) :
(64)
It represents the fact that the coercive authority seizes all of the output and
producers respond by setting e = 0 ever after. This represents a rather
crude expropriation technology where the coercive authority is only able to
expropriate everyone or no-one. We discuss what happens when producers
can be treated di¤erently below.
If the coercive authority has not “cheated” by reverting to = 1, then
its “value function”along the equilibrium path with an expropriation rate of
^ is:
^Y (^)
:
(65)
V^ (^) =
1
An expropriation level ^ is credible if it does not pay to deviate to = 1.
This will be the case if:
V^ (^) V (^) :
(66)
From this, we conclude that an expropriation rate ^ is credible only if
^
(1
51
):
(67)
This expression says that promised expropriation has to be high enough to be
credible. If the expropriation rate is low, then production will be high enough
to tempt the coercive authority to maximally expropriate the producers.
This result implies that a very patient coercive authority ( close to one) can
commit to any rate of expropriation and be credible whereas an impatient
coercive authority ( close to zero) will only be able to commit to a high rate
of expropriation.
Credibility is a binding issue for a coercive authority when it cannot
promise an expropriation rate that maximizes its payo¤. To see this, observe
…rst that the payo¤ maximizing expropriation rate for the coercive authority
in this context is:
1
(68)
= arg max f Y ( )g = :
0
2
The optimal credible expropriation rate maximizes the coercive authority’s
payo¤ subject to the credibility constraint, i.e.
= arg max f X ( )g
^
0
(69)
subject to
(1
):
If the credibility constraint is not binding, then ^ = 1=2. Otherwise,
^ = (1
) > 1=2:.Thus the per period payo¤ to the coercive authority in
a credible equilibrium is:
^=
R
(1
) Y (1
1
Y
2
1
2
)
if < 21
otherwise.
(70)
This logic associates higher output and lower levels of expropriation with
long-lived forms of coercive authority. Thus, as claimed by Olson, reputation acquired by stable autocrats (such as hereditary monarchies) may
perform better than short-lived leaders. The key insight from this analysis
is summarized as:
Result 3.5 The credible rate of expropriation supported by reputation is
g and is therefore decreasing in the
characterized by ^ = maxf 21 ; 1
discount rate of the coercive authority.
We have so far abstracted from the role of natural (unproduced) resources
and their implications for the ability of a coercive authority to commit. However, it is straightforward to extend the above analysis to the case where
52
Z > 0: In this case, V (^) = Y (^) + Z + 1 Z and V^ (^) = ^(Y1(^)+Z) : This
z
yields ^ (1
) + z+y(^
implying that the share of national income that
)
z
is earned from natural resources, z+y(^
, a¤ects the ability to commit. The
)
higher that share, then the higher is the credible expropriation rate, i.e. the
more di¢ cult it is for the government to commit to a low level of expropriation. This reinforces the resource curse …nding from the previous section.
The presence of natural resources also a¤ects the optimal expropriation rate.
2
1
which is increasing in z, the value of “natural
This is now
= A2A+2z
2
2
resources”per producer.
The study by Guriev et al (2008) of nationalizations in the oil industry
around the world over the period 1960-2002 resonates with our analysis.
They …nd that nationalization is more likely to happen when oil prices are
high and the quality of institutions is low even when controlling for country
…xed e¤ects. When oil prices are high the temptation to expropriate is high
(in terms of our model, this can be thought of as a high value of Z).
This analysis assumes that there is a single expropriation rate for all production whether it requires producer e¤ort or not. However, it should be
noted that if the government can separate out property rights to produced
output and natural resources it will wish to do so. Moreover, the reputational mechanism studied here cannot explain how property rights over
natural resources would ever emerge in equilibrium. But given that we observe protection of such property rights in the real world when it is fairly
transparent that there are pure rents to be earned by the state, we need an
alternative explanation than the kind of dynamic reputational model studied
here.
More generally, developing a reputation as a means of enforcing property
rights best …ts with situations where there is no institutionalized restriction
on coercive power. Thus, if it applies at all, this analysis is probably most
relevant to some weakly institutionalized polities where there are no workable formal rules to limit coercion. The main lesson from history is that, if
government is to turn over on a regular basis, then there is a need to move
beyond personal reputations as a means of sustaining property rights protection. Thus, we now move onto understanding other ways of trying to limit
coercive authority.
53
3.1.5
Exit
Another way of preventing coercive power being abused is the possibility that
producers can exercise an exit option. Exit could take the form of leaving
to take an outside option denoted by a utility level u or the ability to hide
or leave with a fraction of output which we denote by .
This can make a di¤erence to the expropriation level and hence output
even when the coercive authority can commit. To see this, recall that in
2
our benchmark static model where z = 0; then y( ) = (1 2 )A : Without any
constraints, the coercive authority would choose = 12 : However, so long as
the producer’s payo¤ when = 1=2 is less than u this is no longer feasible.
A 2
In particular, for u
the exit option will be a binding constraint and
4
i2
h
so the maximum feasible level of will be set by (1 2 )A = u: A similar
result obtains when we allow the producer to leave with a fraction 1
of
his output with > 1=2.
More generally, we can study the no commitment case when the producer can hide, destroy or carry away a fraction 1
of his output when
threatened by expropriation. There is now a maximum tax rate denoted by
=1
. This a¤ects the outcome described in the last section in two main
ways. First, after a deviation from the promised level of expropriation, the
government can only capture Y (^) rather than all of the output. Second,
the upper bound on expropriation may also apply to the expropriation rate
along the equilibrium path which we have labelled ^. Hence, it also provides
an upper bound on expropriation.
The condition for a credible equilibrium level of expropriation when exit
imposes a constraint on expropriation is:
^
(1
).
(71)
This shows exactly how exit can permit the government to credibly commit
to less expropriation. The maximum expropriation rate reduces the lower
bound on ^ . This makes it more likely that the coercive authority can
commit to .
This analysis shows why a government might try to institutionalize exit
options. One way to do this would be through decentralization where multiple governments compete and it is possible to leave one jurisdiction and move
to another if expropriation is too high. Qian and Weingast (1997) refer to
this as “market preserving federalism” which they argue has been relevant
54
as a device to limit expropriation risk in the context of China.
From the perspective of the coercive authority, any exit rate which satis…es
(1
) would be optimal. Such exit options permit the
authority to commit to the expropriation rate that maximizes its ex ante
payo¤.
However, national income and the welfare of producers would still be
higher were it possible to increase exit above the level associated with .
Nonetheless, a purely predatory government would not have an incentive
to protect property rights above the level 1
. But arguably there are
governments around the world that protect property rights to a point where
the state has more or less dispensed with predation. Thus, we need to
consider other explanations of the behavior of such states.
3.1.6
Secrecy
The commitment problem that leads to full expropriation is based on the
assumption that the coercive authority can costlessly observe output. If
this assumption is relaxed, it is possible for the commitment problem to be
mitigated. To make this point as simply as possible, we consider a variant of
our benchmark model. Let e now be discrete: e 2 f0; 1g: If e = 0 then output
is y0 : Otherwise, output is y with probability p; and y with probability 1 p;
where y > y > y0 : Let yb py +(1 p) y denote expected output when e = 1:
To set e = 1, the producer incurs a cost c: Both e¤ort and output are
unobservable to the authority. However, by incurring a cost of the authority
can observe output. The producer, in contrast, knows the level of realized
output, but only after the e¤ort decision is taken. If = 0 then output is
costlessly observable. Then ex post it is always worthwhile for the authority
to observe output and as above, it will always set = 1. As a result, the
producer will select e = 0 and no output will be produced:
As in the previous section, suppose 1
is the part of the output that is
lost to the authority because the producer has some margins of choice: Our
interpretation here is that producers can actually carry away and not just
destroy a fraction 1
of the output. For < 1, the producer will set e = 0
under the assumption that c is su¢ ciently high:
c
(1
)(^
y
y0 ).
(72)
Therefore, the authority can gain an amount R = y0 from expropriation:
55
Suppose instead that > 0. Now whether to observe output is a matter
of choice to the coercive authority. Suppose y0
so that for any output
level it is worthwhile for the coercive authority to expropriate the producer
if it wishes to do so. Would it be worthwhile for the authority to demand a
‡at amount t and observe and expropriate output only if the producer does
not oblige, rather than always observing and expropriating output? We can
interpret this as a fee in exchange for the promise not to expropriate. Is it
possible that this would give the producers the incentive to choose e = 1 and
the authority to partly capture the gains through the ‡at fee? There are
two sets of incentive constraints. First, producers must prefer paying the fee
to being audited and having their output expropriated. Second, the coercive
authority must prefer accepting the fee from a willing producer to auditing
and expropriating.
The producers’incentive constraints are:
y
y
t
t
(1
(1
)y
)y:
(73)
The corresponding constraint for the coercive authority is:
t
t
y
y
(74)
:
As at the time when it decides whether or not to audit, the level of output is
unknown to the coercive authority, the above two expressions can be replaced
by a single one, namely:
t
y^
.
(75)
Combining the relevant constraints yields the following condition for the
incentive compatible fee:
y^
t
y
(76)
Since the authority would prefer as high a fee as possible, then t = y:38
Notice that if is small, the incentive constraint cannot be satis…ed; the
temptation to audit and expropriate is too high for the coercive authority.
38
We are assuming here that the coercive authority can credibly commit to audit and
expropriate if producers o¤er to pay some t0 < t such that y^
t0 : If this is not
possible, then t will have to be set at the lowest level that is consistent with the constraint
of the coercive authority, namely, y^
:
56
We have to make sure that this fee is consistent with the producers’
incentives to choose e = 1 which is the case so long as (using the fact that
t = y):
(77)
y^ (1
)y0
y c:
Notice that now all parties are strictly better o¤.39 Therefore, making it
feasible for its citizens to legally conceal some of their output can be Paretoimproving in this setting.
Some aspects of secrecy are enshrined in the relations between citizens
and government in most modern democracies. While such democracies may
now have the ability to commit not to expropriate in other ways, this may
also re‡ect historical circumstance in which the evolution of these values
about personal freedom were, in the …rst instance, e¢ ciency enhancing and
allowed the ‡ourishing of the market economy. A good example of a modern
day autocratic regime that has embraced some aspects of this in its pursuit
of developing a market economy is China. Bai et al (2004) have emphasized
the use of anonymous banking laws in China as a means of limiting the
possibility of expropriation.
3.1.7
Public Ownership?
We have so far assumed that all production remains in private hands. However, both historical and contemporary experience suggest that we should
take seriously the possibility of public ownership. Thus the state could nationalize all production and employ the citizens to work as wage labourers.
In this case all the surplus in production accrues to the state. Indeed this
is how expropriation has worked in socialist economies.
This section asks whether public ownership can solve the problem of imperfect private property rights. In this case, since the coercive authority
is also the owner and residual claimant then perhaps all the problems that
we have studied so far go away. This view would be correct if all e¤ort
into production were also put in by the coercive authority. However, that is
not realistic. So the interesting case to study is where labor power remains
private while land and other …xed assets are owned by the state.
If a socialist government could enforce the level of e¤ort that maximizes
2
output, which in our example is e = A4 then national income would be
39
If y = y0 then the argument goes through but the authority would have been exactly as
well o¤ as before, not strictly better o¤. This is why we chose this particular formulation.
57
maximal and socialism would be more productive than private ownership.
Indeed, before it was discredited by the experience of Russia and Eastern
Europe, this was a frequent claim made by its proponents. But, as we shall
see, this ignores the standard problem of how workers are to be motivated
when they are not residual claimants.
One thing is clear immediately from our simple model. The question of
the distribution of the surplus is a separate issue from e¢ ciency if the state
2
has the means to set e = A4 . The government may be the residual claimant
or it could choose to leave the fruits of production in the hands of the workers.
In the case of predatory government, public ownership without compensation
would constitute complete but e¢ cient predation now and forever.
But the socialist approach to predation breaks down if there are limited
means for the government to induce e¤ort. This will turn out to generate
parallel problems to those that we have studied so far. To see this, suppose
instead that e¤ort e is private information. Then there is a moral hazard
problem and the state has to o¤er citizens an incentive to work. The wage, w,
is paid only if output is realized as a kind of “incentive payment”.40 Assume
that the outside option of all workers is zero. In this case, the workers will
set their e¤ort at the level:
e = arg max
e 0
p
ew
e =
w2
:
4
(78)
The government which now owns the land on which output is produced earns
all of the expected surplus which is now:
w
(A
2
w).
(79)
It is easy then to see that the optimal wage is w = A=2. The state and the
worker share output equally in the event of a successful project.
It is now easy to see that there is a formal equivalence between what
happens under socialization when the producers are paid a contingent wage
and the case of predation under private ownership where 2 [0; 1] was the
share taken of privately owned output. In the private ownership case, the
coercive authority optimally sets
= 1=2 making the government’s payo¤
under state and private ownership identical. Thus, in this setting, there is
40
There could also be a …xed payment which is paid to workers regardless of whether
output is realized, but we have set this to zero as we are assuming that the aim of the
government is to extract as much surplus as possible from the workers under socialism.
58
no way for public ownership to create either higher returns than a predatory
state with private production or to increase output.
This symmetry between public and private ownership economies is maintained if we now introduce limited commitment under public and private
ownership. Under socialism, the government would have an incentive to
o¤er a wage of A=2 which it would then be tempted to set equal to zero after
output is realized. As with expropriation of privately owned output, this
would create an incentive constraint which would make it impossible for the
government to commit to the wage that was optimal from the point of view
of o¤ering incentives to workers. In the absence of commitment, the workers
would set e = 0. The sustainable level of incentives under commitment
w
(A w)
and
problems would then be w = A which is obtained by equating 2 1
w
41
A.
We would again have an identical outcome under public and private
2
ownership.
So are there reasons to believe that retaining productive assets in private
hands is more e¢ cient as appears to be the case in practice? One possibility
is simply that socialist economies have had trouble acknowledging the need
for incentives at all. Indeed, in many socialist regimes, there has been
aversion to incentives because they create ex post inequality when output
is stochastic. This would imply that output would tend to be lower than
under private ownership provided that private ownership economies can limit
government expropriation. Of course, government might then appeal to nonmonetary incentives such as working to support the motherland etc.
3.1.8
Voice
By far the most important development in government in the past two centuries has been the development of systems of representative government in
which citizens have a say in how private property rights are supported. In
this section, we will discuss how institutional arrangements that enhance the
power over decision making of producers may a¤ect property rights protection.
To study this as simply as possible, suppose that the policy maker puts
a weight of on the utility of producers. This sidesteps the issue of modeling the micro detail of political institutions. This objective function of
41
In the language of contract theory, the coercive authority is now using a relational
contract. See Baker, Gibbons and Murphy (2002) for a discussion in the context of …rms
and workers.
59
government could represent the outcome of some kind of probabilistic voting
model along the lines laid out in Persson and Tabellini (2000) or a lobbying
model along the lines of Grossman and Helpman (1994).42 Either way, this
is consistent with the idea of a “property owning democracy” where owners
of assets have a say in government policy. That said, this formulation might
also crudely capture how preferences are aggregated in an autocratic setting.
The mechanism could also mirror what would happen if a country were ruled
by a more benevolent autocrat who was either fearful of an uprising or genuinely interested in the well-being of its citizens. In the limiting case where
= 1 whoever controls the government values its own rents and the utility
of producers equally.
The payo¤ of the coercive authority is now given by:
!
(1
)2 A2
N
2
(1
)A +
:
(80)
R( )+ N ( ) =
2
2
In a static model without commitment, the government would now choose a
level of expropriation of private production after e¤ort e has been sunk that
maximizes:
p
e =1
(81)
( ) = arg max [ + (1
)] eA
0
as long as
1. Thus, this formulation still leads to full expropriation in
a static setting.43
Observe that, in this case, the coercive authority would like to commit
to the expropriation rate:
1
(82)
=
2
which is decreasing in and equal to 0 for = 1: For = 0, we get the
solution that we studied in section 3.1.4 above.
In a dynamic model, the value of a¤ects the level of property rights
protection that the coercive authority can credibly commit to. To see this, we
now repeat the logic from above and consider what …xed rate of expropriation,
42
Gar…nkel and Lee (2000) and Marceau and Smart (2003) have applied these ideas to
issues related to those studied in this section. See also the historical discussion in Rajan
and Zingales (2003).
43
In fact, we know from Kydland and Prescott (1977) that even a welfare maximizing
government may have an incentive to announced time inconsistent taxation.
60
^ , along the equilibrium path is credible. The condition for no expropriation
beyond the promised level to be credible becomes:
R (^) + N (^)
1
Y (^)
= N
(83)
N e (^)
(1
1
^)
2
(1
^ ) A2
2
:
Solving this equation, we …nd that the expropriation rate is credible only if:
^
1
1
+
=2
:
(84)
Observe that if = 0, then we are back to the condition in equation (5). It
^ = (1
is clear from this that for all
) = 1 2 the coercive authority
can credibly commit to any expropriation rate. Observe that ^ < 1 – so a
democracy in which the government values its own rents and the payo¤ to
citizens equally, i.e.
= 1, will always fully protect their property rights.
For any …xed , a higher value of increases the range of expropriation rates
that the coercive authority can commit to ex ante. Thus, modeling voice in
this way does relax the expropriation incentive constraint of government.
This argument illustrates in a very simple way why institutions that force
decision makers to weight the welfare of producers can lead to a lower expropriation threat and hence increase output in the economy. It explains
why it could be in the interests of a powerful autocrat who cannot commit
to invest in institutions that reduce its power.
These theoretical …ndings are consistent with the crude cross-sectional
observation that democracies tend to be richer than autocracies on average.
However, it is clear that there is likely to be a two-way relationship. Indeed,
there is a large and growing literature on this issue.44
There are a number of historical episodes that resonate with this. It can,
for example, explain the gradual and peaceful transition towards democracy
in the U.K. which was initiated through concessions towards voting and establishing independent legal institutions charged with protecting property
rights. Previous models, such as Acemoglu and Robinson (2000), have discussed the possible role of revolutionary threats in franchise extension. The
current approach emphasizes that there can be a pure self-interest motive if
44
See Persson and Tabellini (2008) for a review and discussion of the issues.
61
the threat of expropriation is too great. Only if is higher can the state
commit to lower rates of expropriation. This could be particularly important when other institutional changes increase political turnover and hence
reduce . The model does suggest that there will be a limit on this mechanism when it is controlled by the coercive authority. It will only have an
interest in improving institutions encouraging producer voice up to the point
where it can implement its own ex ante optimal expropriation rate. This is
supported by institutions of voice, , such that:
1
2
=1
1
+
=2
:
(85)
For all
< , increasing producer voice is Pareto improving. However for
, there is a con‡ict of interest between producers and the coercive
authority.45
3.1.9
Heterogeneous Producers
The analysis so far assumes all producers are treated symmetrically. However, it is possible that property rights are protected di¤erentially across
various social and economic groups. There are a number of possible sources
of heterogeneity suggested by the model so far. The logic of the analysis
above suggests, for example, that producers with greater access to exit opportunities (lower ) and with more in‡uence (higher ) will su¤er less from
expropriation.
However, in the context of the reputational mechanisms that we have
explored, an important issue is how far a coercive authority can selectively
expropriate one group without undermining the trust of others. This depends in part on information ‡ows across groups. In particular, the question
is to what extent one group gets to see any expropriation of the other group.
If one group can be secretly expropriated, then that should not undermine
the con…dence of the other. This suggests the possible role of a “divide and
rule”strategy.46
To illustrate the power of this mechanism to limit expropriation, suppose
that there are two groups J 2 fA; Bg: those with high exit options (A)
and those with low exit options (B). If the state deals with each group
45
46
1
The above condition holds with equality for
= 12 and
> 12 ,
2 . If
See Acemoglu, Robinson and Verdier (2004) for a model along these lines.
62
= 0.
separately, then the credibility constraint is:
^J
(1
)
for J = A; B.
J
(86)
Suppose now that a deviation on either group results in both groups believing
that the coercive authority has cheated on its promise, and that henceforth
it will expropriate both groups at a common rate. This implies that if the
coercive authority chooses to maximally expropriate one group, it will always
maximally expropriate the other group as well, since it will be punished
by both groups anyway. This can work only if there are good information
‡ows between the groups (e.g., via the media). Then the incentive constraint
becomes:
^ Y A (^) + Y B (^)
(1
)
or
^
(1
)
A
AY
NA
+
N
A
B
(^) +
NB
:
N
BY
B
(^)
(87)
(88)
This relaxes the incentive constraint of the coercive authority.47 The intuition
is simple: if it cheats on its promise to group B, in addition to producers in
group B, the producers in group A punish it as well, thereby increasing the
cost of cheating.
If the goal of the political system is to reduce the aggregate level of expropriation, this analysis suggests the importance of two sets of institutions.
First, as we already mentioned, those that permit free ‡ow of information;
and second, solidarity mechanisms in which any kind of expropriation by
the coercive authority is treated as if it is an expropriation of everyone.
3.1.10
Taxation and Expropriation
In our discussion so far, we have not talked about taxation and how it relates
to expropriation. To libertarians taxation is a form of expropriation.48 Ex
post, it might seem it is a matter of semantics as to whether taking away
47
This is an example of a collective reputation mechanism, similar to the one studied
by Greif (1993) for mediaeval traders in the Mediterranean. We have assumed that, even
if there is no collective punishment, the government commits to a common expropriation
rate. Otherwise, the incentive constraint for the group with low exit options would be
relaxed, while the one for the group with high exit options would be strengthened.
48
See Nozick (1974).
63
money from private citizens is called taxation or expropriation. Also, even
from an ex ante point of view, in our framework where everyone is risk
neutral, whether is a tax rate, or the expected probability of expropriation,
seems equivalent so long as these are known before e is chosen.49
If we look across countries of the world, there actually seems to be a
positive correlation between protection of property rights (as measured using
the ICRG expropriation risk measure) and the share of taxation in GDP from
Baunsgaard and Keen (2005). This is illustrated in Figure 3, averaging tax
revenue (as a percentage to GDP) between 1975 and 2000 and the ICRG
expropriation risk score (scale 0-10) averaged between 1984 and 1997. As
argued by Besley and Persson (2007), this type of pattern re‡ects the fact
that countries with more developed …scal systems tend to be richer and, on
the whole, more market-oriented. It brings into sharp relief the idea that
expropriation of property (and not taxation) is symptomatic of a low level
of development.
A key feature of tax systems is precisely that they lay down clearly de…ned rules and enable the citizens to determine their actions accordingly.
Unlike expropriation, taxation is typically an organized and systematized
form of extraction from citizens. Tax systems typically involve published
codes according to which government tries to commit not to levy them ex
post or to discriminate across producers on an ad hoc basis. A key issue is
what enables the government to make this commitment. A natural starting point is the reputation-based story: we can equate expropriation with
government seizing all of the output from the producers while taxation is
the limited expropriation ^ < 1. This distinction between expropriation
and taxation is consistent with Weingast (1997) which argues that a feature
of liberal political institutions (particularly democracy) is to create “fundamental transgressions”–lines in the sand which cannot be traversed without
coordinated punishments. It emphasizes that there is need to have transparent access to information on expropriation by government to give the citizens
49
The fact that taxation is typically deterministic and expropriation stochastic is not
the key distinction in our framework of risk-neutral producers. Indeed, here a meanpreserving spread in the tax rate or the rate of expropriation would raise e¢ ciency so long
as the producer is told which way the uncertainty is resolved before he undertakes e¤ort.
Consider a mean-preserving spread in such that it is with probability p and with
probability 1 p: As the producer’s expected payo¤ is 14 (1
)2 A2 which is convex in
1
it follows that he is better o¤ with the random tax schedule. This is a well-known
result in public …nance –see Weiss (1976).
64
a means to punish governments that violate their property rights.
There is another important di¤erence between taxation and expropriation. Even if we allow for the possibility that taxes too can be subject to
ex post changes, blurring the line between taxes and expropriation from the
commitment point of view, an important issue is whether the producer can
withdraw the asset from production. For example, in the case of land, it can
lie fallow. However, a coercive authority that has the power to expropriate
the owner of his assets, as well as any output that results from it, does not
face this constraint. In principle, the coercive authority can force the asset to
be brought into production. Using our previous arguments on reputation and
exit options we can show that this means even with imperfect commitment,
taxation will provide better incentives than when the coercive authority has
the power to expropriate assets (in addition to output).
To see this formally, suppose there is a discrete decision denoted by 2
f0; 1g which denotes whether the asset is used at all. We assume now that
the production function is:
p
(89)
A e+z :
So if = 0, nothing is produced, while if = 1, then there is output of z
even if e = 0. When the coercive authority cannot expropriate assets then,
the “punishment” that the coercive authority faces if it takes away all the
output from the producer is that output will be zero forever. However, if the
coercive authority can expropriate assets, then output will be z each period.
In the former case, the credible level of expropriation (of output) is ^ 1
.
z
,
which
is
clearly
higher
than
in
In the latter case, it is ^ (1
) + z+y(^
)
the former case.
This argument is even stronger in modern economies given the importance
of inalienable human capital (e.g., Grossman and Hart, 1986).50 To illustrate
this formally, suppose that in the event that the government sets = 1, the
producer can withdraw value equal to 1
from private production in
the form of inalienable speci…c human capital. Then the maximum share of
output that can be expropriated is equal to and, in the dynamic context,
the incentive constraint for the government becomes more relaxed, namely,
^
(1
) (1
):
50
Haber, Maurer and Razo (2003) argue that there is considerable proprietary knowledge
of markets and technology in the Mexican oil industry. They argue that this limited the
amount of expropriation that the government could undertake.
65
3.1.11
Cross-Sectional Empirical Regularities
The models that we have developed above give a crude sense of why, in crosssectional regressions, we might …nd institutional and economic variables that
can explain the extent of expropriation risk by government. Two things
come rather directly out the analysis above. First, we should expect more
stable governments with institutions that constrain government and enhance
voice to have better property rights protection. Second, we should expect
countries with high levels of natural resources to have weaker property rights
protection.
Table 1 looks at these ideas using the ICRG expropriation risk variable
averaged between 1984 and 1997 as the dependent variable. This was used
to construct Figures 1 and 3 above. The variable is on a 0 to 10 scale with
10 denoting the highest level of property rights protection. Its mean is 7.3
and its standard deviation is 1.7.
We use three di¤erent institutional variables as independent variables in
cross-country data for the year 1997.
Our …rst institutional measure is the extent of executive constraints as
measured in the Polity IV data. This variable has a value of 7 when such
constraints are strong. We create a dummy variable equal to one when
countries score 7 and take the average value of this variable between 1945 and
1997. Its mean is 0.24 and its standard deviation is 0.29. Table 1 column
(1) shows that this is negatively correlated with expropriation risk and is
signi…cant at 1%. A one standard deviation in this measure of institutions
leads to little less than half a standard deviation change in expropriation
risk.
There is no direct measure of the government discount factor. However,
Acemoglu, Johnson and Robinson (2001) motivate their use of settler mortality to explain weak property rights use an argument in terms of incentives
to set up long-term and short-term (extractive) institutions. As we have seen
above, long-termism should lead to better property rights protection. The
variable “settler mortality” has a mean of 245 and its standard deviation is
469. Table 1 column (2) shows the results for 64 former colonies for which
this variable is available. As shown by Acemoglu, Johnson and Robinson
(2001), there is a negative correlation between settler mortality and expropriation risk (signi…cant at 1%) with a one standard deviation change in settler
mortality associated with a around one third of standard deviation change
66
in expropriation risk in this sub-sample.51
Another likely factor that shapes short-termism in government behavior
is the incidence of civil war. Civil war could also be a proxy for more
fragmented political authority as war lords may gain control of some parts
of a country. Here, we use a variable derived from the Correlates of War
data base. It is the average number of years between 1945 and 1997 that
a country has been engaged in a civil war. Its mean is 0.06 which says
that in six percent of the country years on average in our sample are in civil
con‡ict and its standard deviation is 0.12. Column (3) in Table 1 shows
again there is a positive correlation between the prevalence of civil war and
expropriation risk which is signi…cant at 1%. In this case a one standard
deviation change in the average civil war variable is associated with a around
a third of a standard deviation change in expropriation risk.
To investigate the resource curse e¤ect on property rights, we use a
dummy variable which is equal to one if a country is an oil exporter. The
mean is 0.12 and the standard deviation is 0.32. Column (4) of Table 1 shows
that there is a positive correlation between expropriation risk and being an
oil exporter which is signi…cant at 10%.
Being an oil exporter increases
expropriation risk by half of one standard deviation.
Column (5) includes all these variables together on the sample of colonies
for which settler mortality data is available. The correlations that we uncovered in the earlier columns remain signi…cant with the exception of the
oil exporter dummy variable.
While only suggestive, these …ndings support the relevance of the underlying theoretical reasoning that we explored throughout this section. The
link between these reduced form correlations and speci…c theories is tenuous
and one challenge for future empirical work in this area is to forge a closer
link between theory and data.
3.2
Improving State E¤ectiveness
E¤ective states in the current context are those that support institutions that
allow households and …rms to enjoy secure property rights. This constitutes
a key investment in state legal capacity of the kind emphasized in recent
51
In an ingenious paper, DeLong and Shleifer (1993) look indirectly at property rights
protection in Medieval Europe and …nd that absolutist monarchs presided over slower
growth in urbanization.
67
work by Besley and Persson (2007, 2008). They formulate a dynamic model
where such investments are forward looking and state capacity accumulates
over time. For simplicity of exposition, we will focus here on a simpler static
approach. This will emphasize how heterogeneous interests, and the way
that these are mediated through political institutions, shape the decisions
that states make to improve property rights protection.
To formalize this, we need a cost function which maps public expenditures on market supporting property rights into lower in the notation of
this chapter. Concretely, these costs can be thought of as the resources
needed to fund courts and property registries. We will black box this by
simply writing this cost function as L (1
) where L ( ) is an increasing,
convex function measuring the per capita cost of improving property rights
at an economy wide level. This function could vary across countries due to
di¤erent legal traditions and hence could constitute the way in which legal
origins along the lines of La Porta et al (1998) enter the determination of
market supporting property rights.52 For example, if common law countries
are better at protecting asset owners from encroachment on their rights or
in enforcing some kinds of contracts, then @L (1
) =@ could be lower in
these cases, i.e. a lower marginal cost of delivering a given level of property
rights protection.
Funding L (1
) can be through either general taxation or through a
set of user fees, e.g. paying to register property or to use the court system.
Deciding on the method of …nance is a societal decision which will have
implications for the level of investment that is likely to take place. Also important for the decision to invest in the capacity to support e¤ective property
rights will be the way in which political institutions shape collective choice.
This will matter most when there is signi…cant heterogeneity in the population. The analysis so far has given many reasons why we would expect such
heterogeneity in practice.
This section will lay out a rudimentary way of thinking about this and
the insights that are aided by having the explicitly micro-founded models
from section 2. However, it will be clear that improving state e¤ectiveness
in terms of property rights is not fundamentally di¤erent from any dimension
of public spending that has an impact on productivity in the economy, such
as extending education or building infrastructure. These also have to deal
52
See Glaeser and Shleifer (2002) for an interesting discussion of the historical political
economy behind the development of di¤erent legal codes.
68
with issues that arise due to heterogeneous costs and bene…ts within the
population.53
Another theme in this sub-section will be the interplay between formal
and informal institutions in providing legal services needed to support property rights. One aspect of low income countries is the role of social networks
in ensuring that property can be used as collateral or traded. For example, traditional land rights in Africa often require that the lineage or tribal
authority has jurisdiction in this domain. This can be important since the
incentives of the state to provide property rights could depend on such private informal alternatives. After all, if informal provision is e¤ective then
there may be no need for any kind of state investment. We can think of this
in the way that we suggested in section 2.2.2 where we supposed that there
was value of N that is speci…c to the network with a value of F where F
stands for “formal”which is relevant in the market. The latter could then be
54
improved by collective investments represented by the function L (1
F ).
In general, the case for state provision lies in extending the domain of
trade. A legal system based on networks provides contract enforcement services only to members of that network creating a patchwork of di¤erent N ’s:
In principle, the formal legal system F could be available to all households
and …rms in the economy creating a common basis for trade. To the extent
that F is lower this will tend to foster arms-length trade which will raise
output.
3.2.1
A Simple Benchmark
To illustrate some of the issues involved in a simple and stylized way, we will
work with the model of section 2.2.1. While this was motivated as a model of
expropriation risk rather than market supporting property rights we can use
the interpretation that improving the court system allows better protection
against claims by others to the fruits of the output. We will suppose that
among the N producers there are di¤erent levels of productivity or land
53
However, in a dynamic setting (as emphased by Besley and Persson (2007)), there is a
distinction between investments that enhance the set of future feasible policy options and
actual policy changes. Decisions on the former require looking forward to possible changes
in political control.
54
In line with this idea, Rajan and Zingales (1998) argue that economies with weak
legal systems rely relatively more heavily on personalized trading rather than arms length
relationships. See Fafchamps (2005) and Platteau (2000) for discussion and analysis of
informal networks.
69
holding represented by Ai with i = 1; :::; N . The payo¤ to typical producer
is:
2
(1
) Ai
+ e:
(90)
(Ai ; ) =
2
Suppose that each producer were faced with the per capita cost of sustaining
property rights protection paid via a general lump-sum levy on all producers.
Producer i’s preferred level of formal property rights protection would then
be:
(Ai ) = arg max f (Ai ; ) L (1
)g :
(91)
2[0;1]
The fact that Ai and are complements implies that ( ) will be a decreasing
function, i.e. more productive producers will prefer better property rights
protection (lower ).
To make a prediction about the level of property rights protection that
would be chosen in this economy, we need to know whose preferences are
decisive in collective choices over . As a benchmark, we will consider
the outcome of a median voter model where those that bene…t from weaker
property rights are a negligible fraction of the population and hence do not
in‡uence the choice of policy.55
Since preferences over are single-peaked, then a standard median voter
model would predict that in a democracy, this will be the median value of
Ai , denoted by Am . Thus, according to this we will see (Am ).
In this simple case, the distribution of productivity in the economy (perhaps re‡ecting the underlying distribution of assets) would a¤ect the location
of the median voter and hence the level of formal property rights protection
in the economy as a whole. This simple model could give a foundation as
to why legal origins matter, if we think that it a¤ects the function L ( ).
The median voter in a country with a lower marginal cost of property rights
protection will tend to choose better property rights protection.
3.2.2
Extensions
Our median voter result is a useful benchmark result. However, there are
reasons to be doubtful that it captures the full set of issues that are relevant
to decisions to invest in property rights protection in reality. We will now
discuss some departures from this benchmark and discuss how they may
a¤ect the result.
55
This expropriating group are therefore best thought of as a small elite.
70
Many developing countries are not democracies and it is fanciful to think
that the median producer could be most relevant for determining . Some
form of elite rule where richer producers have more political power might
seem more natural. If the elite were simply rich producers who use the
formal legal system to protect their property rights, then we would expect
giving them the right determining would actually increase property rights
protection. So economies dominated by a producer elite may tend to towards
higher output and greater income per capita.
However, another (and perhaps more plausible) interpretation of elite rule
would be for the rentier class who live o¤ the fruits of weak property rights
have a say in political decision making. To make things simple, suppose
that the rentiers act together in a uni…ed way –a strong uni…ed elite and do
not face any cost from investing in the legal system (this remaining incident
on the producers). Then, their payo¤ is:
)X
N
(1
2
(Ai )2 :
(92)
i=1
It is clear that their choice of property rights protection would be = 1=2
whatever the cost of investing. Whether this is greater or less than would be
desired by the median producer is not immediately clear. However, for small
enough investment costs and a higher enough level of productivity for the
median producer, we would expect there to be a con‡ict of interest with more
producer oriented polities favouring stronger protection of property rights
compared to those run by the rentier class. While not clear-cut, this does
give some presumption for believing that property rights protection would
be better in more democratic societies. These …ndings are in line with some
of the discussions of Engerman and Sokolo¤ (2002) and their discussion of
the role of inequality in shaping a variety of policy choices. However, as
argued by Acemoglu and Robinson (2005), there is the possibility that fear
of a revolution could lead to a policy choice by the elite that is closer to that
of the wider citizens. Both of these observations are consistent with our
earlier discussion of the impact of democracy on expropriation risk.
The existence of networks may also have implications for the political
economy of property rights protection. Some groups, for example, may be
able to enjoy good levels of property rights by trading in networks and hence
without recourse to improving state e¤ectiveness. Models of oligarchic property rights as developed by Acemoglu (2003) and Braguinsky and Myerson
71
(2007) can be thought of in such terms. In a world where the ruling elite
enjoy privileged access to a superior level of N , there may be little incentive to improve property rights for the wider economy (see Sonin (2003)).
However, Besley and Persson (2008) argues that the force of this argument
depends on the development of the tax system, since the ruling elite would be
better o¤ maximizing production e¢ ciency and then taxing the bene…ts for
its own ends. This is essentially an application of the Diamond and Mirrlees
(1971) e¢ ciency theorem. This kind of network based argument presents
a somewhat di¤erent reason why fragmented authority can be damaging to
property rights development.
3.2.3
Empirical Regularities
The theoretical discussion gives a feel for why there should be di¤erence in
states’e¤ectiveness in supporting property rights. We would expect this to
depend on the level of economic development (measured via the Ai ’s in terms
of the theory), the political institutions and the legal history which a¤ects
the workings of legal institutions. To explore this in a very preliminary
way, Table 2 presents some cross-sectional regressions based on data from
the World Bank’s Doing Business web site (www.doingbusiness.org). The
variable that we look at is the one of property registration which tries to get
at how easy it is to register property under the law.56 While this is only
a partial perspective on the issues that interest us, it is certainly indicative
and is available for 172 countries. The variable that we use is the summary
ranking of each country’s performance across three indicators: cost, number
of procedures and time.
In Table 2 column (1), we correlate this variable with the log of income
per capita and …nd a strong negative correlation, i.e. countries with higher
income levels have better systems for registering property. Of course, the
direction of causality is hard to know. A one standard deviation change
in log income per capita is associated with around 20 places in the country
ranking.
In column (2), we look at the correlation with legal origins, with French
legal origin being the omitted category. There are strong correlations with
56
The data “records the full sequence of procedures necessary when a business purchases
land and a building to transfer the property title from another business so that the buyer
can use the property for expanding its business, as collateral in taking new loans or, if
necessary, to sell to another business.”
72
Socialist, Scandinavian and German legal origin all of which have better
rankings compared to French legal origin. These …ndings are in line with La
Porta et al (1998).
Column (3) in Table 2 looks at the correlation with democracy using the
Polity data for the period from 1945 to 2000. The variable that we use
measures the proportion of years in the year 2000 for which the country has
had a polity score greater than zero over this period. Moving from being
continuously autocratic to continuously democratic over this period is worth
around 45 places in the ranking suggesting that policies that enable property
registration are superior in democracies.
Finally, in column (4), we include all of these sets of variables. Although
the magnitudes of the correlations change, the basic …ndings are robust.
As with the earlier results, these are only suggestive correlations and they
in no sense test the theoretical models that we have put forward. However,
they hint at the possible empirical relevance of the ideas that we have laid
out and breath life into the theory. But much remains to be done to re…ne
our understanding of these issues at an empirical level in a way that is linked
to theory.
4
Concluding Comments
Market economies rely on the creation and enforcement of property rights.
In this chapter, we have reviewed the ways in which property rights a¤ect
economic decisions, and the incentives for creating e¤ective institutions for
the protection of private property.
Economists have often approached the problem of designing public policies by taking the starting point of market failure –typically where a competitive market fails to internalize externalities or there is a lack of competition.
But the study of markets rests often on assumptions about e¤ective property
rights which cannot be taken for granted. The role of competitive markets
in allocating resources is then quite limited. This observation is especially
relevant in the context of …nancial markets given the importance of assets in
supporting trade.
The issues studied in this chapter are, we believe, of …rst order importance in studying the development process and there is now a wide variety
of supporting evidence. Looking at the evolution of property rights also
means integrating insights from historical experience. This chapter has, we
73
hope, given a sense of the richness of the issues that are involved in studying the interplay between property rights and economic development. It
also has created a uni…ed analytical framework drawing from the literature
on development economics, political economy, and econonomics of contracts
and organizations. However, it has not been possible to cover things in as
much depth as we would have liked to, nor have we been able to provide a
thorough survey of the literature.
One key message that stands out is how one should be cautious in thinking
about property rights extension in a monolithic way. The creation of e¤ective
property rights is heterogeneous in its impact and there are many potential
mechanisms that can sustain property rights. This suggests that there should
not be a “one size …ts all”mantra of extension of private property rights, nor
a blind faith that this is a magic bullet that will cure all economic ills.
74
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2
4
6
8
10
Figure 1: Expropriation Risk and Income per capita
6
7
8
9
Log Income per capita
Average Expropriation Risk (ICRG)
10
Fitted values
11
0
50
100
150
200
Figure 2: Property registration and Income per capita
6
7
8
9
Log Income per capita
Property Protection (Rank)
10
Fitted values
11
2
4
6
8
10
Figure 3: Expropriation Risk and Tax Revenue
0
10
20
30
40
Tax Revenue to GDP (average 1975-2000)
Average Expropriation Risk (ICRG)
Fitted values
50
Table 1: Expropriations in Selected Countries
France, 1307-1312
From 1307 onwards, Philip IV of France seized assets of the Knight Templars to alleviate France’s serious
financial problems. Five years later, Pope Clement V, pressured by the French King, abolished the order
and transferred part of their assets to the Hospitallers. The value of the seized assets were likely
significant as the Knights Templars operated the first known international banking network using their
military strongholds.
England, 1536-1541
Between 1536 and 1541 King Henry VIII expropriated monasteries in England and took over their land,
amounting by some estimates to over 30 percent of the land holdings in England at that time. Some of
the land and buildings went into the ownership of the crown, others were sold to the gentry. One of the
unwanted side-effects of the expropriation was the creation of a powerful upper class in England which
became a serious restriction on the King’s policies thereafter.
United States, 1870-1910 Expropriation was commonly used as an instrument of public policy, designed to subsidize private
enterprises in Railway construction, Milling and Mining. Expropriations and legislation supporting them
were common in the United States at that time. Colorado's constitutional convention of 1875-76, for
example, stated that private property might be taken for "private ways of necessity, ... reservoirs, drains,
flumes, or ditches on or across lands of others, for mining, milling, domestic, or sanitary purposes".
Mexico, 1936-1938
As part of President Cardenas six year plan, the Mexican government expropriated direct investments in
Agriculture, Railway and particularly Petroleum. Estimates of the Brookings institution put the value of
expropriated properties belonging to US citizens to over $ 300 million. The reaction was an AngloAmerican boycott, decreasing oil exports and eventually a devaluation of the peso. Foreign direct
investment contracted by more than two thirds between 1935 and 1940.
Iran, 1951
British oil production facilities in Iran were expropriated under Prime Minister Mohammad Massadeq.
In response, Britain boycotted Iranian oil depriving the country from its largest market. Supported by
the US and England, pro-monarchy forces toppled the government in 1953.
Egypt, 1956
Following a withdrawal of American and British finance for the Aswan Dam, President Nasser
nationalized the Suez Canal in 1956. The nationalisation was the trigger to an armed conflict in the
region including Isreal, France and Britain and the occupation of Egypt.
Cuba, 1959-1960
Following the Cuban Revolution in 1958, the Cuban government seized properties belonging to US
nationals with an estimated value of $ 1.8 billion. This was a higher amount than the total amount
expropriated by all other Communist countries combined. The sectors most affected were public
services, Sugar growing and milling and Oil refining. The US government sanctions Cuba from the 1960s
onwards. Disruption in trade was enormous as trade links with the US were close. The World Bank
estimates that real GDP per capita was steadily decreasing for at least a decade after the expropriation.
Algeria, 1971-1980
In 1971, President Boumediene inaugurated the “agrarian revolution" – a large scale land reform which
aimed at partial redistribution and nationalization of large land holdings. Absentee landowners were to
be entirely expropriated. While a significant share of landowners avoided redistribution, over 1.3 million
hectares had been distributed to nearly 100,000 beneficiaries by 1980. In the period following the
reforms, productivity dropped drastically and agrarian production suffered. Partial reversal of reforms
in the 1980s could not prevent heavy dependence on imports and rising food prices followed by social
unrest.
Chile, 1971
Led by President Allende, the Chilean government expropriated US copper mining companies of assets
worth more than $ 500 million. Expropriations were carried out through a constitutional amendment
approved by the Chilean Congress in 1971. The case triggered conflict with the US companies and
government and was followed by withdrawal of credit.
Zimbabwe, 2000-2001
When the political mood seemed to swing against him in February 2000, Zimbabwe's president Mugabe
launched a programme of land redistribution. The relatively chaotic programme was spearheaded by his
party’s paramilitary wing who began occupying white owned farms around the country. The land was
taken, divided and sold or given to peasants and party supporters. In the years following the
expropriation, Zimbabwe's economy featured negative growth and rising levels of inflation. The country
has increasingly become dependant on food aid.
Sources: Martin (2004), Barber (1994), Rajan and Zingales(2003); Scheiber (1973); Baklanoff (1975); Searingen (1990); World Development
Indicators.
(1)
High Constraints
on the Executive
(Polity IV))
(2)
(3)
-2.249***
(0.515)
Settler Mortality
-0.001***
(0.000)
-0.001**
(0.000)
-5.359***
(1.238)
Oil Exporter
123
0.154
(5)
-1.545**
(0.644)
Average years in
civil conflict 19451997 (COW)
Observations
R-squared
(4)
64
0.105
129
0.149
-3.029**
(1.409)
-0.790*
(0.453)
0.122
(0.494)
122
0.022
61
0.265
Notes: Dependent variable is Average Expropriation Risk from the International Country Risk Guide for years 1984 through 1997. Robust standard errors in
parentheses: * significant at 10%; ** significant at 5%; *** significant at 1%
Table 2: Cross-Sectional Determinants of Expropriation Risk
(1)
Log Income per capita
(2)
(3)
-20.790***
(3.303)
(4)
-10.648***
(4.023)
English Legal Origin
-11.387
(8.953)
-0.953
(8.982)
Socialist Legal Origin
-32.951***
(9.835)
-40.314***
(10.606)
Scandinavian Legal
Origin
-87.751***
(7.332)
-46.793***
(13.234)
German Legal Origin
-66.984***
(8.955)
-32.330***
(11.619)
Proportion of years in
democracy 1944-2000
(Polity)
Observations
R-squared
130
0.225
169
0.162
-44.550***
(10.729)
-28.369**
(12.621)
172
0.094
130
0.349
Notes: Dependent variable is a country’s rank (1-172) on the World Bank Doing Business web site for time, number of procedures and cost of registering
property. Legal origin omitted category is French legal origin. Robust standard errors in parentheses: * significant at 10%; ** significant at 5%; *** significant
at 1%.
Table 3: Cross-Sectional Determinants of Property Registration